PUBLIC  UTILITIES 

THEIR 

COST   NEW   AND 
DEPKECIATION 


BY 

HAMMOND  V.  HAYES,  PH.D. 

CONSULTING    ENGINEER 


NEW  YORK 

D.  VAN  NOSTRAND  COMPANY 

25  PARK  PLACE 

1913 


COPYRIGHT,     1913 
BY    D.    VAN    NOSTRAND    COMPANY 


THETLIMPTONTRESS 

NORWOOD-MASS'U-S-A 


PEEFACE 

THE  valuation  of  public  utility  undertakings  is  a  mixed 
question  of  fact,  judgment  and  law.  A  comprehensive 
treatment  of  this  subject  requires  the  combined  knowledge 
of  the  engineer,  the  economist  and  the  lawyer.  The  fol- 
lowing pages,  written  by  an  engineer,  cannot  be  offered  as 
an  authoritative  discussion  of  the  legal  questions  involved. 
On  the  other  hand  the  engineer,  who  is  called  upon  to 
prepare  and  present  most  of  the  figures  required  by  courts 
and  commissions  as  evidence  of  the  value  of  the  property 
of  such  undertakings,  must  have  a  sufficient  knowledge 
of  the  legal  questions  that  are  at  issue  to  enable  him  to 
obtain  properly  and  intelligently  the  figures  needed  by 
the  tribunals  whose  duty  it  is  to  assign  the  fair  present 
value.  This  must  be  offered  in  explanation  of  the  many 
quotations  from  decisions  of  courts  and  commissions 
which  have  been  incorporated  in  the  present  volume. 

It  has  seemed  to  many  who  have  studied  this  subject 
that  the  precedents  are  diverse  and  that  much  must  yet 
be  done  before  the  fair  present  value  of  the  property  of 
public  utilities  can  be  defined.  It  is  a  question  whether 
general  rules  can  ever  be  laid  down  as  to  what  the  fair 
present  value  will  be  in  all  cases.  It  would  seem  as  if  such 
value  must  always  be  determined  by  "the  well  instructed 
judgment"  of  a  broad  minded  and  impartial  tribunal. 
But  even  admitting  this,  a  careful  reading  of  all  available 


iv  PREFACE 

decisions  shows  that  much  of  the  diversity  is  produced 
by  a  lack  of  understanding  on  the  part  of  the  engineer  of 
what  is  meant  by  "  original  cost"  and  by  "depreciation." 
The  efforts  of  the  engineer  in  most  appraisals  appear  to 
have  been  concentrated  upon  the  ascertainment  of  the 
replacement  cost  to  the  entire  neglect  of  original  cost. 
Moreover,  "depreciation"  has  been  confused  with  "de- 
terioration" and,  as  a  consequence,  the  loss  in  value  of  a 
property  has  been  made  dependent,  in  some  way  or  other, 
upon  the  physical  efficiency  of  the  plant. 

The  object  of  the  present  work  has  been  largely  to  bring 
to  the  minds  of  those,  whose  duty  it  is  to  ascertain  the 
figures  representative  of  value,  three  distinct  issues  :  first, 
that  it  is  the  duty  of  the  appraiser  not  to  ascertain  the 
fair  present  value,  that  function  belongs  to  the  court  or 
commission,  but  to  ascertain  with  accuracy  such  figures 
as  are  necessary  evidences  of  value  and  loss  of  value; 
second,  that  the  original  cost  can  be  obtained  without 
inordinate  difficulty  and  is  a  figure  of  importance  to  those 
who  must  rule  as  to  what  the  fair  present  value  should  be; 
and  third,  that  depreciation  is  affected,  only  indirectly 
by  inefficiency  and  that,  as  a  necessary  consequence,  de- 
preciation is  dependent  wholly  upon  the  relation  of  the 
age  to  the  life  of  the  perishable  property. 

It  is  appreciated  that,  as  a  practical  matter,  evidence 
as  to  possible  value  will  be  offered  by  experts  employed 
by  one  side  or  the  other  in  a  controversy,  and  that,  as  a 
necessary  consequence,  such  experts  will  be  inclined  to 
advocate  figures  most  favorable  to  the  interests  of  their 
employers.  On  the  other  hand,  it  is  a  fact  that  a  long 
step  toward  the  removal  of  the  present  apparent  diver- 
sity of  rulings  will  have  been  made  when  the  experts' 


PREFACE  V 

figures  faithfully  represent  the  true  replacement  cost, 
the  actual  original  cost  and  the  real  loss  in  value  due  to 
depreciation. 

It  is  hoped  that  the  following  pages  may  aid  in  reaching 
this  desirable  and  necessary  result. 

HAMMOND  V.  HAYES 
BOSTON,  June  2,  1913. 


CONTENTS 

CHAPTER  I 

PROPERTY  VALUATIONS  —  GENERAL  CONSIDERATIONS 

PAGE 

1.  Purpose  of  present  treatise 1 

2.  Limitation  as  to  expert  evidence  relative  to  property  value  .      .  2 

3.  Present  value  dependent  upon  purpose  of  appraisal    ....  3 

4.  True  present  value  to  be  determined  by  court  or  commission  only  4 

5.  Figures  to  be  presented  as  indicating  possible  present  value  5 

6.  Original  cost 6 

7.  Replacement  cost '  .  7 

8.  Depreciation 7 

9.  Market  value  of  bonds  and  stocks 7 

10.  Capitalization  of  earnings 8 

11.  Worth  of  service  to  the  consumer 8 

12.  Cost  and  value 9 

13.  Value  as  "  going  concern  " 10 

14.  Determination  of  fair  present  value 14 

15.  Figures  showing  value  independent  of  purpose  of  valuation  .      .  15 

16.  Necessity  of  presenting  all  figures  indicative  of  possible  present 

value  .      .  16 


CHAPTER  II 
REPLACEMENT  COSTS  OF  PHYSICAL  PROPERTY 

17.  Definition  of  replacement  cost 18 

18.  Present  or  original  conditions 19 

19.  General  assumptions  as  to  replacement 19 

20.  New  plant  identical  with  old  or  one  of  modern  design      ...  20 

21.  Effect  upon  replacement  cost  of  increased  difficulty  in  placing 

plant  . 21 

22.  Period  of  construction 23 

23.  Unit  costs 25 

24.  Mean  unit  costs  developed  from  curves  showing  trend  of  market 

prices 27 

25.  Use  of  weighted  mean  prices  during  period  of  construction   .      .  28 

26.  Piecemeal  vs.  wholesale  construction 29 

27.  Piecemeal  construction.     Effect  of  changes  and  enlargements 

on  cost 32 

28.  Pavement  over  construction 33 


viii  CONTENTS 


CHAPTER  III 

DETERMINATION  OF  REPLACEMENT  COST 

PAGE 

29.  Inventory 35 

30.  Plant  elements 36 

31.  Costs 37 

32.  Items  included  in  unit  costs 38 

33.  Units  costs  —  Costs  of  material 39 

34.  Unit  costs  —  Costs  of  labor 39 

35.  Unit  costs  —  Losses  on  tools  and  material 40 

36.  Unit  costs  —  Insurance 41 

37.  Overhead  charges  —  General  consideration 41 

38.  Overhead    charges  —  Interest    during    construction.     General 

consideration 42 

39.  Overhead    charges  —  Interest    during     construction.      Mean 

weighted  time 46 

40.  Overhead  charges  —  Interest  during   construction.       Rate   of 

interest 47 

41.  Overhead  charges  —  Engineering 49 

42.  Overhead  charges  —  Organization  expense 51 

43.  Overhead  charges  —  Legal  expense 52 

44.  Overhead  charges  —  Contingencies .  52 

45.  Overhead  charges  —  Other  possible  costs 53 

46.  Promotion  costs 54 

47.  Sale  of  securities 56 

48.  Contractor's  profit 57 

49.  Overhead  charges  —  Method  of  application 57 

50.  Real  estate 61 

51.  Cost  of  land  affected  by  cost  of  hypothetical  buildings    ...  64 

52.  Cost  of  buildings 68 


CHAPTER  IV 
VALUE  AS  GOING  CONCERN 

53.  Value  inherent  in  an  operating  plant 69 

54.  Value  of  plant  in  use  dependent  upon  purpose  of  appraisal  .  71 

55.  Fundamental  conception  of  value  inherent  in  "live  plant"  .      .  72 

56.  Capitalization  of  present  net  earnings 73 

57.  Capitalization  of  present  and  anticipated  net  earnings     ...  75 

58.  Value  not  dependent  upon  cost  alone 75 

59.  Capitalization  of  profits 76 

60.  Analytical  methods  of  determining  value  inherent  in  a  live  plant  78 

61.  Wisconsin  method 79 

62.  Reproduction  of  net  earnings  method 83 

63.  Doubt  as  to  inclusion  of  going  value  in  rate  cases       ....  85 

64.  General  consideration  of  value  inherent  in  a  live  plant    ...  87 

65.  Practical  usefulness  of  methods  of   determining  value  in  live 

plant 91 


CONTENTS  ix 


CHAPTER  V 

VALUES  OF  GOOD  WILL  AND  FRANCHISES 

PAGE 

66.  Good  will  and  franchise  values  attributes  of  value  inherent  in 

live  plant 94 

67.  Goodwill 95 

68.  Franchise  —  General  consideration 96 

69.  Value  of  franchise  in  case  of  sale 97 

70.  Value  of  franchise  in  cases  involving  the  equity  of  a  statutory 

rate 98 

71.  Value  of  franchise  in  valuations  for  taxation 100 

CHAPTER  VI 
ORIGINAL  COST 

72.  Necessity  of  an  unbiased  determination  of  original  cost   .      .      .  102 

73.  Original  cost  required  by  court  decisions 103 

74.  Neglect  in  past  of  figures  showing  original  cost 104 

75.  Abandoned  or  destroyed  plant  cannot  be  given  value      .      .      .  104 

76.  Difficulty  in  obtaining  original  cost 107 

77.  Unit  costs 109 

78.  Piecemeal  construction 109 

79.  Pavement  over  construction Ill 

80.  Overhead  charges        112 

81.  Sale  of  securities 112 

82.  Cost  of  developing  business 114 

CHAPTER  VII 

COMMERCIAL  VALUE 

83.  Three  figures  to  be  presented  under  head  of  commercial  value     115 

84.  Relative  importance  of  figures  representing  the  market  value 

of  stocks  and  bonds 115 

85.  Method  to  be  used  in  ascertaining  the  market  value  of  stocks 

and  bonds 119 

86.  Method  of  ascertaining  value  based  on  capitalization  of  net 

earnings 120 

87.  Liabilities 122 

CHAPTER  VIII 
THE  WORTH  OF  SERVICE  TO  THE  CONSUMER 

88.  Decisions  as  to  worth  of  service 125 

89.  Rates  based  on  different  substituting  plant  not  a  criterion  of 

worth 127 

90.  Rates  in  other  communities  not  a  criterion  of  worth         .      .      .      127 

91.  Profit  inherent  in  worth 128 


X  CONTENTS 

PAGE 

92.  Worth  of  service  to  be  measured  by  what  it  would  cost  the 

public  to  furnish  the  same  service 129 

93.  Overbuilt  plant 130 

CHAPTER  IX 

RESERVES  FOR  DEPRECIATION 

94.  Investment  in  perishable  property  a  wasting  asset    .      .      .      .  133 

95.  Authority  for  depreciation  reserves 134 

96.  Current  repair  and  maintenance 136 

97.  Salvage  value 139 

98.  Wearing  value 139 

99.  Importance  of  accurate  determination  of  probable  life  of  units  140 

100.  Creation  of  depreciation  reserves 140 

101.  Creation  of  reserve  fund  by  "sinking  fund"  method       .      .      .  141 

102.  Creation  of  reserve  fund  by  "straight  line"  method.      .      .      .  142 

103.  Creation  of  reserve  fund  —  Authority  for  use  of  "sinking  fund" 

or  "straight  line"  method 142 

104.  Mean  life  of  plant 144 

105.  Danger  of  misconception  of  mean  life 145 

106.  Adoption   of   "sinking  fund"   or   "straight  line"  method  of 

making  reserves  in  practical  cases 146 

107.  Straight  line  method 147 

108.  Sinking  fund  method 149 

109.  Reserves  invested  in  plant 150 

110.  Reserves  for  depreciation 155 

CHAPTER  X 
LIFE  OF  PLANT 

111.  Life  of  plant 158 

112.  Continuation  of  undertaking 159 

113.  Interest  of  public  in  operation  of  public  utility 160 

114.  Interest  of  public  in  depreciation  reserves 161 

115.  Maintenance  and  depreciation  reserves 163 

116.  Importance  of  "life"  in  a  determination  of  depreciation     .      .  163 

117.  Life  of  a  plant  unit 164 

118.  Physical  life 164 

119.  Factors  affecting  life  of  plant 165 

120.  Inefficiency 165 

121.  Wear  and  tear  of  plant 168 

122.  Obsolescence 169 

123.  Inadequacy  —  Definition 171 

124.  Inadequacy  —  Changes  in  financial  policy 172 

125.  Inadequacy  —  Engineering  economy 176 

126.  Inadequacy  —  Unexpected  development 176 

127.  Operation  of  factors  affecting  useful  life  of  plant  units  .      .      .  177 

128.  Probable  life  of  various  plant  elements 178 

129.  Limited  tenure  of  holding 180 


CONTENTS  xi 

CHAPTER  XI 

DEPRECIATION 

PAGE 

130.  Definition 182 

131.  Physical  condition  not  a  direct  measure  of  loss  of  value      .      .  183 

132.  Determination  of  age 185 

133.  Mean  "life"  and  mean  "age" 186 

134.  Determination  of  loss  of  value  a  problem  in  accountancy    .      .  187 

135.  Shall  loss  in  value  due  to  age  be  figured  by  straight  line  or  sink- 

ing fund  method? 188 

136.  Return  to  undertaking  based  upon  fair  value  of  property  .      .  189 

137.  Loss  in  value  of  plant  arising  from  age 190 

138.  Loss  in  value  of  property  consisting  of  plant  and  reserves  .      .  194 

139.  Justice  of  the  rule  as  to  use  of  straight  line  or  sinking  fund 

method 196 

140.  "Pseudo"  mean  age 197 

141.  Loss  in  value  of  property  when  all  reserves  have  been  held  in- 

vested in  outside  securities 198 

142.  Loss  in  value  of  property  consisting  of  plant,  built  partly  with 

reserves,  and  of  reserves 202 

143.  General  consideration  of  loss  in  value  due  to  age      ....  204 

144.  Question  as  to  necessity  of  reserves  sufficient  to  maintain  value 

of  original  investment 205 


CHAPTER  XII 
FAIR  PRESENT  VALUE  —  RATES 

145.  Fair  present  value  determined  by  "well-informed"  judgment  .  207 

146.  Two  kinds  of  rate  cases,  —  state  and  court 208 

147.  Fair  present  value  dependent  upon  purpose  of  valuation     .      .  209 

148.  Fair  present  value.     Valuation  for  state  regulation  ....  210 

149.  Fair  present  value.     Valuation  for  court  investigation  .      .      .  210 

150.  Cost  new  of  property  —  State  investigation  of  rates       .      .      .  211 

151.  Increased  value  of  real  estate 212 

152.  Paving 216 

153.  Property  acquired  by  gift 216 

154.  Cost  new  of  property.     Investigation  by  court  of  statutory 

rates 217 

155.  Increased  value  of  real  estate 218 

156.  Cost  of  repaving 218 

157.  Property  acquired  by  gift *  .      .      .  218 

158.  Value  inherent  in  live  plant 219 

159.  Brokerage  —  Discounts 219 

160.  Tendency  of  later  decisions  to  establish  a  fair  cost-new       .      .  222 

161.  Depreciation 223 

162.  Method  of  figuring  depreciation  in  cases  involving  rates      .      .  224 

163.  Returns  based  upon  capital  investment 226 


xii  CONTENTS 

PAGE 

164.  Investment  in  property,  not  plant,  ruled  by  courts  as  basis  of 

fair  return .  227 

165.  Dangers  resulting  from  making  present  value  of  plant  alone  the 

basis  of  fair  rates 229 

166.  Valuation  of  new  properties 229 

167.  Working  capital 230 

168.  Fair  return 231 

169.  Fair  rate  based  upon  stock  only  or  upon  stock  and  bonds    .     .  233 


CHAPTER  XIII 

FAIR  PRESENT  VALUE  —  CONDEMNATION  OR  SALE 

170.  Market  value 235 

171.  Fair  cost-new 236 

172.  Increased  cost  of  maintenance 237 

173.  Uncertainty  as  to  life 237 

174.  Value  of  franchise 238 

175.  Depreciation  in  cases  of  sale 238 

176.  Investment  of  buyer  must  be  full  cost-new  of  a  public  utility 

property 239 

177.  Present  value  in  case  of  sale  240 


CHAPTER  XIV 

GENERAL  CONSIDERATION  RELATIVE  TO  THE  REGULATION  OP    PUBLIC 
UTILITY  UNDERTAKINGS 

178.  Conduct  of  private  undertakings 244 

179.  Conduct  of  public  utility  undertakings 245 

180.  Dangers  involved  in  regulation  of  public  utility  undertakings  245 

181.  Avoidance  of  dangers  of  regulation 247 

182.  Obligations  of  public  to  public  utility  undertaking        .      .      .  248 

183.  Obligation  of  public  utility  undertaking  to  the  public    .     .      .  250 

184.  Maintenance  of  the  value  of  the  stockholders'  investment.      .  251 

185.  Treatment  of  depreciation  reserves 254 

186.  General  conclussion  255 


PUBLIC   UTILITIES: 

THEIR    COST    NEW  AND   DEPRECIATION 

CHAPTER  I 

PROPERTY  VALUATIONS  — GENERAL   CONSIDERATIONS 

1.  Purpose  of  present  treatise. 

2.  Limitation  as  to  expert  evidence  relative  to  property  value. 

3.  Present  value  dependent  upon  purpose  of  appraisal. 

4.  True  present  value  to  be  determined  by  court  or  commission  only. 

5.  Figures  to  be  presented  as  indicating  possible  present  value. 

6.  Original  cost. 

7.  Replacement  cost. 

8.  Depreciation. 

9.  Market  value  of  bonds  and  stocks. 

10.  Capitalization  of  earnings. 

11.  Worth  of  service  to  the  consumer. 

12.  Cost  and  value. 

13.  Value  as  "going  concern." 

14.  Determination  of  fair  present  value. 

15.  Figures  showing  value  independent  of  purpose  of  valuation. 

16.  Necessity  of  presenting  all  figures  indicative  of  possible  present  value. 

1.  Purpose  of  present  treatise.  —  The  increasing  super- 
vision by  state  authorities  in  the  United  States  of  the 
operation  of  public  service  undertakings  has  necessitated 
valuations  of  the  properties  employed  by  many  classes  of 
utilities.  Much  of  the  work  which  has  been  done  in 
making  such  valuations  has  been  carried  out  under  the 
direction  of  engineers  of  wide  experience,  who  have 
formulated  methods  which  have  been  designed  to  furnish 
data  upon  which  the  true  present  value  of  the  property 
under  investigation  could  be  determined  with  as  near  an 
approach  to  accuracy  as  is  possible.  On  the  other  hand, 


2  PUBLIC  UTILITIES 

a  careful  study  of  the  details  of  the  methods  used  by 
the  various  engineers  and  by  the  commissions,  who 
have  been  engaged  upon  this  work,  shows  a  considerable 
variation  both  in  the  theories  and  principles  which  have 
been  followed.  It  is  of  interest  and  of  great  importance 
that  all  such  variations  should  be  noted  and  the  funda- 
mental principles,  involved  in  any  complete  valuation, 
be  defined  so  clearly  that  two  competent  and  experi- 
enced engineers  presenting  figures  as  to  the  value  of  the 
same  property,  independently,  would  obtain  substan- 
tially the  same  results. 

An  attempt  has  been  made  to  record  in  the  following 
pages  the  principles,  as  far  as  they  have  been  established, 
which  must  form  the  basis  of  a  valuation  of  the  property 
of  a  public  utility  undertaking.  References  have  been 
given  to  decisions,  which  have  been  rendered  in  many 
important  cases,  bearing  upon  this  subject. 

2.  Limitation  as  to  expert  evidence  relative  to  property 
value.  —  As  will  be  shown  later,  the  fair  present  value 
of  the  property  of  an  undertaking  must  be  determined 
by  a  judicial  weighing  of  figures  showing  possible  pres- 
ent values  determined  by  radically  different  methods. 
Some  of  these  figures  can  be  obtained  only  by  engineers 
familiar  with  properties  of  the  character  of  that  under 
valuation.  Other  figures  can  be  determined  most  accu- 
rately by  experts  on  financial  and  economic  problems. 
The  figures  presented,  tending  to  show  value  based  on 
engineering  and  economic  considerations,  involve  many 
questions  of  law  which  can  be  answered  only  by  one  hav- 
ing a  full  knowledge  of  the  laws  bearing  on  cases  of  this 
character.  This  knowledge  of  the  law  is  particularly 
necessary  in  forming  a  judgment  as  to  the  relative  weight 
to  be  given,  in  each  particular  case,  to  the  several  esti- 
mates of  present  value  presented  by  the  experts.  In 
consequence  of  the  wide  range  of  expert  knowledge 


PROPERTY  VALUATIONS  3 

required  in  the  determination  of  fair  present  value,  some 
of  the  courts  have  excluded  expert  testimony  except 
for  the  purpose  of  substantiating  the  particular  figures 
tending  to  show  the  value  that  can  be  assigned  to  a 
property  when  determined  by  methods  on  which  they 
are  qualified  by  experience  and  training  to  speak.  They 
have  held  that  valuation  is  a  mixed  question  of  fact, 
judgment  and  law  and  that  the  court  itself  is  compe- 
tent only  to  assign  the  true  value  of  the  property  by  a 
judicial  consideration  of  the  facts,  figures  and  law  in- 
volved in  each  particular  case. 

3.  Present  value  dependent  upon  purpose  of  appraisal. 
-  Most  of  the  valuations  which  have  been  made  thus 
far  have  had  for  their  object  a  determination  of  the  proper 
value  of  the  property  of  an  undertaking  as  a  basis  for 
taxation  or  for  a  determination  of  proper  rates  to  be 
charged  for  the  service  or  commodity  sold  by  the  under- 
taking to  the  public.  In  consequence  of  this,  rulings 
have  been  made  by  the  courts  and  decisions  given  by 
public  service  commissions,  which  offer  many  suggestions 
as  to  methods  of  valuation  applicable  to  investigations 
for  these  two  purposes.  But,  in  addition  to  valuations 
designed  as  a  basis  for  taxation  or  for  rate  regulation, 
appraisals  are  frequently  required  to  determine  the  pres- 
ent value  of  a  property  prior  to  the  issue  of  new  securities, 
or  to  determine  a  price  fair  to  the  public,  as  well  as  to 
vendor  and  vendee,  when  a  transfer  of  the  property  of  a 
public  utility  undertaking  becomes  necessary  in  a  case 
of  sale.  It  is,  therefore,  important  in  any  comprehen- 
sive study  of  the  question  of  values  of  property  to  deter- 
mine how  far  the  methods  of  valuation  employed  must 
be  modified  to  produce  the  true  present  value  for  any  one 
of  these  four  purposes. 

Many  writers  on  this  subject  have  contended  that  the 
fair  present  value  of  a  property  must  be  the  same  for 


4  PUBLIC  UTILITIES 

whatever  purpose  such  value  may  have  been  determined 
and  that,  in  consequence,  there  can  be  but  one  method 
by  which  the  true  present  value  can  be  obtained.  That 
such  is  not  the  case  will  be  apparent  when  the  entire 
subject  of  valuation  has  been  fully  discussed.  As  will 
be  presently  shown  the  fair  present  value  of  the  property 
of  an  undertaking  must  be  found  by  a  judicial  consider- 
ation of  a  number  of  sets  of  figures  each  purporting  to 
show  the  value  of  the  property  at  the  time  of  the  appraisal 
when  determined  from  different  points  of  view.  Thus, 
speaking  generally,  one  set  of  figures  may  be  the  value 
which  engineers  would  place  upon  the  property,  another 
would  be  based  upon  what  the  users  of  the  utility  would 
feel  that  they  should  pay  for  the  service  rendered,  an- 
other would  be  what  the  owners  had  paid  for  the  prop- 
erty, another  might  be  based  on  the  earning  capacity 
of  the  property,  and  another  would  be  what  the  invest- 
ing public  at  large  thought  of  the  commercial  value  of 
the  property.  In  most  cases  each  one  of  these  values 
will  be  different  and  possibly  no  one  value  will  be  that 
which  will  be  assigned  as  the  true  present  value.  The 
relative  weight  which  will  be  given  to  these  figures  will 
be  different  depending  upon  the  purpose  for  which  the 
appraisal  is  made,  as  well  as  upon  the  special  conditions 
affecting  the  property  under  consideration. 

4.  True  present  value  to  be  determined  by  court  or 
commission  only.  —  A  careful  study  of  the  subject  of 
the  valuation  of  public  utility  undertakings  shows  that 
each  one  of  the  sets  of  figures,  described  in  the  last  sec- 
tion as  designed  to  show  a  value  determined  from  differ- 
ent points  of  view,  must  be  obtained  without  any  regard 
whatever  to  the  purpose  of  the  appraisal.  These  figures 
are  not  designed  to  show  the  true  present  value  of  the 
property.  The  true  present  value  of  the  property  can 
be  established  only  by  the  impartial  judgment  of  the 


PROPERTY  VALUATIONS  5 

court  or  commission,  weighing  the  conditions  affecting 
each  particular  case. 

Whatever  relative  weight  may  be  given  to  these  sets 
of  figures,  each  set  should  be  capable  of  determination 
along  well  established,  logical  and  proper  lines,  lines 
which  have  been  defined  so  well  that  no  controversy 
need  arise  as  to  the  reliability  of  the  figures  presented. 

5.  Figures  to  be  presented  as  indicating  possible  pres- 
ent value.  —  Authority  for  the  presentation  of  these 
diverse  figures  has  been  given  by  many  rulings  of  the 
Courts  of  the  United  States.  This  is  defined  most  clearly 
in  a  decision  of  Mr.  Justice  Harlan  in  a  case  relative  to 
the  reasonableness  of  rates: 

"If  a  railroad  corporation  has  bonded  its  property  for  an 
amount  that  exceeds  its  fair  value,  or  if  its  capitalization  is 
largely  fictitious,  it  may  not  impose  upon  the  public  the  burden 
of  such  increased  rates  as  may  be  required  for  the  purpose  of 
realizing  profits  upon  such  excessive  valuation  or  fictitious  cap- 
italization; and  the  apparent  value  of  the  property  and  fran- 
chises used  by  the  corporation,  as  represented  by  its  stocks, 
bonds  and  obligations,  is  not  alone  to  be  considered  when 
determining  the  rates  that  may  be  reasonably  charged.  .  .  . 

We  hold,  however,  that  the  basis  of  all  calculations  as  to 
the  reasonableness  of  rates  to  be  charged  by  a  corporation  main- 
taining a  highway  under  legislative  sanction  must  be  the  fair 
value  of  the  property  being  used  by  it  for  the  convenience  of 
the  public.  And  in  order  to  ascertain  that  value,  the  original 
cost  of  construction,  the  amount  expended  in  permanent  im- 
provements, the  amount  and  market  value  of  its  bonds  and 
stock,  the  present  as  compared  with  the  original  cost  of  con- 
struction, the  probable  earning  capacity  of  the  property  under 
particular  rates  prescribed  by  statute,  and  the  sum  required  to 
meet  operating  expenses,  are  all  matters  for  consideration,  and 
are  to  be  given  such  weight  as  may  be  just  and  right  in  each 
case.  We  do  not  say  that  there  may  not  be  other  matters  to 
be  regarded  in  estimating  the  value  of  the  property.  What 
the  company  is  entitled  to  ask  is  a  fair  return  upon  the  value 
of  that  which  it  employs  for  the  public  convenience.  On  the 


6  PUBLIC  UTILITIES 

other  hand,  what  the  public  is  entitled  to  demand  is  that  no 
more  be  exacted  from  it  for  the  use  of  a  public  highway  than 
the  services  rendered  by  it  are  reasonably  worth." 1 

The  figures,  therefore,  which  should  be  presented  to 
the  court  or  commission  in  order  that  it  may  determine 
the  true  present  value  judicially  with  "  sound  and  well 
instructed  judgment "  are,  - 

1.  Figures   showing   the   original   cost   of   the   entire 
property  used  and  useful  to  the  public  at  the  time  of 
appraisal. 

2.  Figures  showing  the  cost  new  at  the  present  time 
of  the  same  property,  i.e.,  the  cost  new  of  reproduction 
or  the  replacement  cost. 

3.  Figures  showing  the  loss  in  value  of  the  invest- 
ment in  the  property  arising  from  its  years  of  service,  i.e., 
the  depreciation. 

4.  Figures  showing  the  amount  and  market  value  of 
its  bonds  and  stocks. 

5.  Figures  showing  the  commercial  or  capitalized  value 
of  the  business  of  the  undertaking  based  upon  present 
as  well  as  possible  future  earnings,  i.e.,  the  probable  gross 
earnings  less  present  or  possible  future  operating  expenses. 

6.  The  reasonable  worth  of  the  service  rendered  to  the 
public,  i.e.,  to  the  consumers  or  users. 

6.  Original  cost.  —  The  original  cost  is  the  actual 
amount  of  money  expended  by  the  undertaking  for  the 
property  then  in  use  for  the  convenience  of  the  public. 

The  original  cost  of  the  plant  is  not  necessarily  what 
was  paid  for  portions  first  constructed.  If  the  plant  has 
been  extended,  the  original  cost  includes  the  cost  of  such 
extensions.  It  may  be  that  the  original  plant  has  been 
replaced  in  whole  or  in  part.  If  such  replacements  have 
neither  increased  nor  decreased  the  value  of  the  plant, 
then  the  original  cost  still  holds.  If  the  replacement 

1  Smyth  v.  Ames,  169  U.  S.  546,  (1898). 


PROPERTY  VALUATIONS  7 

has  cost  more  than  was  paid  for  the  plant  that  is  replaced, 
then  a  virtual  extension  of  the  plant  has  been  made  and 
the  total  original  cost  must  be  enhanced.  If  the  plant 
has  been  rebuilt  for  less  than  it  cost  originally,  then  the 
total  original  cost  must  be  reduced. 

7.  Replacement  cost.  —  Mr.  Justice  Harlan  ruled  that 
the  " present  cost"    of   construction   should   be   deter- 
mined so  that  it  can  be  compared  with  the  original  cost. 
Replacement  cost  is  such  "present  cost,"  and  may  be 
defined  as  that  amount  of  money  which  would  have  to 
be  expended  at  the  present  time  to  bring  into  existence 
a  property  identical  with  that  of  the  undertaking  being 
appraised.     It  must  be  obtained  by  an  inventory  of  all 
of  the  property  of  the  undertaking  and  by  a  valuation 
of  such  property  based   upon   complete   and   carefully 
developed  units  of  cost. 

8.  Depreciation.  —  Depreciation  is  the  loss  in  value 
which  has  occurred  arising  from  the  period  during  which 
the  property  of  the  undertaking  has  been  in  service. 

It  must  be  recognized  that  depreciation  applies  only  to 
such  of  the  units  of  the  property  as  suffer  a  loss  in  value 
due  to  the  years  of  service  and,  consequently,  is  appli- 
cable principally  to  the  plant  units,  but  many  plant 
units  suffer  no  depreciation  and,  in  consequence,  the 
method  of  presenting  the  values  of  the  elements  of  prop- 
erty must  be  such  that  the  factors  of  depreciation  can 
be  properly  applied. 

9.  Market  value  of  bonds  and  stocks.  —  This  method 
of  valuation  is  known  as  the  " stock  and  bond  method" 
and  consists  in  obtaining  the  present  value  of  the  com- 
mercial property  of  an  undertaking  by  multiplying  the 
par  value  of  outstanding  corporate  liabilities  by  their 
market  quotations. 

"The  method  of  valuing  railway  properties  on  the  basis  of 
the  market  quotations  of  their  stocks  and  bonds  is  regarded 


8  PUBLIC  UTILITIES 

by  many  as  the  most  defensible  of  all  methods,  for  the  reason 
that  the  price  of  railway  securities  established  on  the  stock 
exchanges  is  the  resultant  of  a  combination  of  the  greatest  pos- 
sible number  of  judgments.  Thousands  of  men  are  constantly 
endeavoring  to  surpass  one  another  in  the  fullness  and  accuracy 
of  their  knowledge  of  the  value  determining  factors  affecting 
any  given  security  and  to  turn  their  superior  knowledge  into 
profits.  The  inevitable  outcome  of  this  process  is  the  estab- 
lishment of  a  list  of  prices  which  represents  the  crystallization 
of  the  best  judgment  respecting  the  value  of  property;  and 
when  these  prices  are  determined"  with  care  "over  long  periods 
of  time,  ...  no  objection  can  reasonably  be  made  against 
their  use  on  the  ground  of  their  speculative  character."  l 

This  method  unquestionably  affords  an  excellent  basis 
for  comparison  with  the  present  values  as  determined 
from  original  cost  or  replacement  cost,  but  it  must  be 
recognized  clearly  that  a  commercial  value  as  thus 
obtained  must  presuppose  the  probable  continuance  of 
existing  rates  for  the  utility  sold. 

10.  Capitalization  of  earnings. — This  method  of  deter- 
mining the  present  commercial  value  of   the  property 
of  an  undertaking  consists  in  capitalizing  the  net  income 
of  the  undertaking  after  deducting  operating  expenses, 
depreciation,  and  taxes,  from  the  gross  revenue.     This 
method  presents  two  difficulties,  —  the  elimination  from 
operating  expenses  of  the  cost  of  permanent  improve- 
ments which  may  have  been  charged  to  this  account 
rather  than  to  the  capital  account,  and  the  determina- 
tion of  a  proper  rate  of  capitalization.    Attention  should 
be  called  also  to  the  fact  that  in  this  method,  as  in  that 
just  described,  the  income  of  the  undertaking  is  depend- 
ent upon  the  rates  charged  for  the  utility  sold. 

11.  Worth  of  service  to  the  consumer.  —  Fundamen- 
tally the  worth  of  a  service  to  a  consumer  is  what  it  would 
cost  him,  when  working  co-operatively  with  other  users 

1  U.  S.  Census  Bulletin  21,  p.  19. 


PROPERTY  VALUATIONS  9 

of  the  same  utility,  to  provide  the  same  service,  taking 
into  consideration  that,  by  obtaining  service  from  an 
undertaking  rather  than  from  a  plant  built  and  operated 
with  his  and  his  associates'  money,  he  is  relieved  from 
all  annoyance,  responsibility  and  risk.  It  is  not  a  fig- 
ure intended  to  show  what  it  might  cost  individual  users 
to  provide  a  similar  service  for  themselves  individually, 
but  when  acting  as  a  community.  It  is  not  a  value 
capable  of  determination  by  comparison  with  the  cost  of 
the  same  character  of  utility  furnished  in  other  commu- 
nities. Nor  is  it  necessarily  based  upon  what  it  would 
cost  to  obtain  the  same  result  by  the  use  of  another  util- 
ity, as,  for  example,  the  relative  cost  of  obtaining  the  same 
amount  of  light  from  gas  when  the  worth  of  that  light 
obtained  from  electricity  was  involved. 

12.  Cost  and  value.  —  The  object  of  a  valuation  is  to 
obtain  the  true  present  value  of  a  property,  or,  stated 
more  accurately,  to  obtain  the  value  at  a  particular  date 
which  would  be  fair  and  just  to  all  concerned  under  all 
the  conditions  prevailing  in  that  special  and  particular 
case. 

It  is  to  be  noted,  however,  that  the  first  two  of  the 
above  sets  of  figures  are  costs,  original  cost  and  replace- 
ment cost,  not  values,  whereas  the  three  last  sets  of  fig- 
ures are  values.  The  original  cost  and  the  replacement 
cost  must  be  translated  into  values  in  some  way,  in  order 
that  they  may  be  comparable  with  the  others  and,  con- 
sequently, be  of  service  to  the  court  or  commission 
whose  duty  it  is  to  weigh  all  the  figures  presented  as 
representative  of  value,  and  from  them  assign  that  value 
which  is  fair  under  all  of  the  conditions  of  the  case. 

Value  is  indicative  of  a  desire  on  the  part  of  someone 
who  does  not  possess  an  object  and  who  cannot  acquire 
it  without  parting  with  something  that  he  has  in 
exchange  for  it.  It  is  the  difference  in  desire,  measured 


10  PUBLIC  UTILITIES 

in  money,  which  is  supposed  to  exist  on  the  part  of  per- 
sons with  different  interests,  which  creates  the  variation 
in  present  value  which  may  be  assigned  to  the  same 
property  depending  upon  the  purpose  of  the  valuation, 
whether  for  sale,  for  rate  regulation,  for  taxes  or  for  the 
issue  of  securities. 

Original  cost  or  cost  of  replacement,  therefore,  is  not 
indicative  of  value  necessarily.  The  cost  of  the  physical 
property  of  an  undertaking,  either  when  originally  con- 
structed or  rebuilt  at  the  present  time  but  not  in  use, 
might  be  very  large  but  such  costs  would  not  be  indic- 
ative of  the  value  of  the  property.  The  property 
would  have  value,  would  be  desired,  only  when  it  had 
been  enlivened  by  operation  or  could  be  shown  that  it 
could  be  so  enlivened  and  made  capable  of  producing  a 
return. 

These  two  figures,  original  cost  and  replacement  cost, 
must  be  translated  into  value  and  this  can  be  done  only 
by  including  with  such  cost  figures  representative  of  the 
value  inherent  in  the  physical  property,  produced  by  the 
fact  that  the  physical  property  consists  of  a  live  plant, 
composed  of  units  in  co-ordination  and  articulation  with 
each  other,  and  "thus  forming  a  complete  mechanism, 
capable  of  performing  useful  service,"  productive  or 
potentially  productive  of  a  return  to  the  owners. 

This  enlivening  factor  is  frequently  called  the  value  of 
a  property  as  a  "going  concern." 

13.  Value  as  "going  concern " — It  is  to  be  noted  that 
the  figures,  to  be  presented  as  indicating  value,  are  to 
represent  the  value  of  the  property  of  the  undertaking. 
The  property  of  a  public  utility  rarely  consists  of  plant 
alone.  The  undertaking  has  other  property  of  distinct 
value  to  it  and  to  the  public,  which  is  not  apparent  or 
tangible  and  consequently  cannot  be  made  a  portion  of 
an  inventory  as  can  the  physical  property.  This  intan- 


PROPERTY  VALUATIONS  11 

gible  property  consists  of  the  value  inherent  in  the  util- 
ity due  to  the  fact  that  the  utility  is  operating  a  "live 
plant,"  a  plant  connected  with  users. 

This  value  inherent  in  a  live  plant,  or,  as  it  is  frequently 
called,  "value  as  a  going  concern,"  has  been  recognized 
in  most  of  the  later  decisions  bearing  upon  the  value  of 
the  properties  of  public  utilities.  The  decision  of  Mr.  Jus- 
tice Lurton  in  the  Omaha  Water  Case  brings  out  very 
clearly  this  intangible  value. 

"The  option  to  purchase  excluded  any  value  on  account  of 
unexpired  franchise;  but  it  did  not  limit  the  value  to  the  bare 
bones  of  the  plant,  its  physical  properties,  such  as  its  lands, 
its  machinery,  its  water  pipes  or  settling  reservoirs,  nor  to  what 
it  would  take  to  reproduce  each  of  its  physical  features.  The 
value  in  equity  and  justice  must  include  whatever  is  contrib- 
uted by  the  fact  of  the  connection  of  the  items  making  a  com- 
plete and  operating  plant.  The  difference  between  a  dead 
plant  and  a  live  one  is  a  real  value,  and  is  independent  of  any 
franchise  to  go  on,  or  any  mere  good  will  as  between  such  a 
plant  and  its  customers.  That  kind  of  good  will,  as  suggested 
in  Willcox  v.  Consolidated  Gas  Co.  (212  U.  S.  19),  is  of  little 
or  no  commercial  value  when  the  business  is,  as  here,  a  natural 
monopoly,  with  which  the  customer  must  deal,  whether  he  will 
or  no.  That  there  is  a  difference  between  even  the  cost  of  du- 
plication, less  depreciation,  of  the  elements  making  up  the  water' 
company  plant,  and  the  commercial  value  of  the  business  as  a 
going  concern,  is  evident.  Such  an  allowance  was  upheld  in 
National  Waterworks  v.  Kansas  City,  (62  Fed.  Rep.  853), 
where  the  opinion  was  by  Mr.  Justice  Brewer.  We  can  add  .^ 
nothing  to  the  reasoning  of  the  learned  Justice,  and  shall 
not  try  to.  That  case  has  been  approved  and  followed  in 
Gloucester  Water  Company  v.  Gloucester,  (179  Mass.,  365),  and 
Norwich  Gas  Company  v.  city  of  Norwich,  (76  Conn.  565). 
No  such  question  was  considered  in  either  Knoxville  v.  Knoxville 
Water  Company,  (212  U.  S.  1),  or  in  Willcox  v.  Consolidated 
Gas  Company,  (212  U.  S.  19).  Both  cases  were  rate  cases, 
and  did  not  concern  the  ascertainment  of  value  under  contracts 
of  sale."  * 

1  City  of  Omaha  v.  Omaha  Water  Company,  218  U.  S.  212,  (1910). 


12  PUBLIC  UTILITIES 

In  another  case  the  Court  says: 

"Nevertheless  it  has  value  as  a  structure.  But,  more  than 
this,  it  is  a  structure  in  actual  use;  a  use  remunerative  to  some 
extent.  It  has  customers.  It  is  actually  engaged  in  business. 
It  is  a  going  concern.  The  value  of  the  structure  is  enhanced 
by  the  fact  that  it  is  being  used  in,  and  in  fact  is  essential  to, 
a  going  concern  business.  We  speak  sometimes  of  a  going  con- 
cern value  as  if  it  is  or  could  be  separate  and  distinct  from 
structure  value  —  so  much  for  structure  and  so  much  for  going 
concern.  But  this  is  not  an  accurate  statement.  The  going 
concern  part  of  it  has  no  existence  except  as  a  characteristic 
of  the  structure.  If  no  structure,  no  going  concern.  If  a 
structure  in  use,  it  is  a  structure  whose  value  is  affected  by  the 
fact  that  it  is  in  use.  There  is  only  one  value.  It  is  the  value 
of  the  structure  as  being  used.  That  is  all  there  is  of  it.  ... 
The  district  obtains  and  the  company  yields  its  plant,  its  struc- 
ture; but  it  is  the  structure  as  being  used,  with  the  rights  to 
use  it  as  stated;  no  less,  no  more.  We  apprehend  that  some 
difficulty  in  discussion  has  arisen  from  attempting  to  differ- 
entiate in  logic  what  is  inseparable  in  fact.  The  property  taken 
is  a  single  thing,  to  which  belong  certain  characteristics  which 
affect  its  value.  The  thing  cannot  be  taken  without  these 
characteristics.  If  it  is  attempted  to  value  the  thing  separate 
from  its  inherent  characteristics,  elements  which  add  value  to 
the  thing  are  omitted.  If  these  elements  are  omitted,  the  owner 
fails  to  receive  the  full  and  fair  value  of  the  thing,  and  thereby 
is  denied  just  compensation."  l 

The  opinion  of  Mr.  Justice  Lurton  above  quoted  clearly 
indicates  the  distinction  which  must  exist  between  cost 
and  value  when  the  plant  has  been  quickened  or  vitalized 
by  operation.  The  original  cost  and  replacement  cost 
must  be  presented,  therefore,  in  such  a  way  as  to  show 
not  only  the  cost  of  the  physical  property  but  the  value 
inherent  in  that  property  as  a  "live"  plant,  productive 
or  potentially  productive,  of  a  return  to  the  owners. 
Fundamentally  the  value  inherent  in  a  live  plant  is  meas- 

1  Brunswick  &  Topsham  Water  Dist.  v.  Maine  Water  Co.,  59  Atl.  539, 
(1904). 


PROPERTY  VALUATIONS  13 

ured  by  its  earning  capacity,  and  this  earning  capacity, 
except  for  the  control  exercised  by  the  State  over  Public 
Utilities,  would  be  due  to  some  characteristics  of  the  prop- 
erty inherent  in  the  position  of  the  plant  or  of  its  opera- 
tion. /THus  in  the  case  of  a  railroad  the  trend  of  tonnage 
down^fade  rather  than  up  grade;  of  the  density  of  pop- 
ulation and  traffic  as  related  to  the  location  of  the  road; 
of  the  value  to  the  road  of  facilities  for  producing  business 
for  the  road,  such  as  grain  warehouses  or  elevators,  flour 
mills,  saw  mills  and  manufacturing  establishments  of 
all  kinds;  of  the  low  cost  of  fuel;  of  ownership  of  water- 
power  rights  sufficient  to  provide  for  electrical  operation 
on  mountain  grades;  of  the  availability  of  skilled  em- 
ployees; or  of  reasonable  costs  of  living.  All  of  the  con- 
ditions of  this  character  may  tend  greatly  to  enhance 
the  value  of  the  property  but  they  are  all  characteris- 
tic of  the  plant  location,  are  inherent  in  the  plant  as  an 
operating  organization  and,  in  consequence,  any  values 
that  may  attach  properly  to  them  must  be  considered  as 
a  portion  of  the  value  of  the  property. 

"The  value  of  a  railway  system  does  not  depend  upon  the 
mere  cost  of  its  embankment  or  its  equipment.  It  is  rather  a 
question  of  location,  of  connections,  of  terminal  facilities,  of 
enterprises  along  its  line;  and  shall  nothing  be  allowed  to  the 
foresight  and  ability  which  have  marked  out  and  perfected 
that  system?"1 

But  in  the  case  of  a  public  utility,  the  state  has  the 
power  to  say  what  rates  and,  consequently,  what  return 
can  be  earned  by  the  organization  operating  under  con- 
ditions of  a  location  which  has  been  granted  to  it.  The 
state  need  not  consider  the  relative  advantages  of  one 
undertaking  as  compared  with  another  offering  substan- 
tially the  same  service.  Each  undertaking  stands  by 
itself  and,  in  .case  of  a  controversy  which  is  carried  to 

1  Interstate  Commerce  Commission  Reports,  Vol.  IX,  p.  402. 


14  PUBLIC  UTILITIES 

the  courts,  the  court  decides  simply  whether  the  rates 
imposed  will  afford  such  a  low  return  upon  the  present 
true  value  of  the  property  as  may  be  deemed  confisca- 
tory  of  the  property  of  the  undertaking.  All  of  the  rul- 
ings of  the  counts,  however,  recognize  that  the  live 
plant,  the  plant  enlivened  by  successful  operation,  is 
more  valuable  than  the  bare  bones  of  the  physical  plant, 
and  agree  that  some  enhancement  in  value  should  be 
made  by  them  in  a  determination  of  the  true  present  value 
of  a  property. 

The  value  inherent  in  a  live  plant  includes  other  ele- 
ments than  that  of  its  value  as  a  going  concern,  such  as 
the  value  of  "good  will"  or  the  value  of  the  " franchise 
rights."  Whether  or  not  definite  values  can  be  attrib- 
uted to  each  of  these  factors  individually,  and  whether 
such  values,  if  present,  can  be  included  as  a  part  of  pres- 
ent value  of  a  property  in  all  cases,  will  be  considered  in  a 
later  chapter. 

14.  Determination  of  fair  present  value.  —  The  court 
or  commission,  depending  upon  the  nature  of  the  case, 
is  alone  competent  to  assign  the  true  present  value  of 
the  property  of  an  undertaking.  For  the  purpose  of 
aiding  such  decision,  the  above  six  sets  of  figures  have 
been  ruled  by  Mr.  Justice  Harlan  as  requisite.  In  form- 
ing its  decision  the  tribunal  must  base  its  judgment  upon 
the  facts  and  figures  applying  to  each  particular  case. 
No  hard  and  fast  rules  have  ever  been  laid  down  and 
probably  never  can  be  laid  down  to  govern  all  cases.  This 
is  clearly  indicated  in  the  decision  rendered  in  the  Spring 
Valley  case  which  is  quoted  below :  — 

"He  is  entitled  to  a  fair  return,  not  always  upon  the  cost  of 
the  property,  because  it  may  have  cost  too  much;  not  always 
upon  the  outstanding  indebtedness,  because  it  may  be  in  excess 
of  the  real  value  of  the  property;  not  always  upon  the  total 
amount  invested,  because  some  portion  of  that  which  is  acquired 


PROPERTY  VALUATIONS  15 

by  the  investment  may  be  neither  necessary  nor  presently  use- 
ful for  the  public  service;  but  upon  the  fair  present  value  of 
that  which  is  used  for  the  public  benefit,  having  due  regard 
always  to  the  reasonable  value  of  the  service  rendered.  Each 
case  must  depend  very  largely  upon  its  own  special  facts,  and 
every  element  and  every  circumstance  which  increases  or  depre- 
ciates the  value  of  the  property,  or  the  service  rendered,  should 
be  given  due  consideration,  and  allowed  that  weight  to  which 
it  is  entitled.  It  is,  after  all,  very  much  a  question  of  sound 
and  well-instructed  judgment."  1 

These  figures  derived  and  presented  in  accordance 
with  the  rules  formulated  in  the  succeeding  pages  provide 
the  tribunal  with  complete  and  accurate  information 
as  to  possible  values  of  the  property.  With  the  infor- 
mation afforded  by  these  figures  carefully  and  logically 
determined,  a  decision  can  be  formed  as  to  a  present 
value  which  will  be  fair  to  all  parties  concerned.  In 
some  cases  one  figure  representative  of  value  may  be 
given  more  weight  than  it  would  be  in  another  case.  In 
many  cases  the  present  value  will  be  a  compromise  figure 
for  the  reason  that  a  public  service  corporation  differs 
from  a  private  undertaking  in  that  the  tribunal  must 
consider  what  is  fair  to  the  public  as  well  as  to  the  under- 
taking. Likewise  in  a  case  of  sale,  the  present  value  must 
be  a  fair  one  looking  to  the  interests  of  the  public  as  well 
as  to  those  of  the  buyer  and  seller. 

15.  Figures  showing  value  independent  of  purpose  of 
valuation.  —  It  is  the  tribunal  which  determines  which 
figure  representative  of  value  must  be  given  weight  or 
by  how  much  such  a  figure  should  be  modified.  The 
experts,  engineer  or  accountant,  cannot  change  the  method 
of  valuation  by  means  of  which  the  figures  which  they 
are  to  present  to  the  tribunal  are  to  be  derived  in  order 
to  produce  their  conception  of  present  value.  The  orig- 

1  Spring  Valley  Water  Works  v.  San  Francisco,  165  Fed.  680. 
See  also  Ames  v.  Union  Pacific  R.  R.,  64  Fed.  165. 


16  PUBLIC  UTILITIES 

inal  cost  can  be  but  one  definite  figure.  It  may  be  a 
figure  difficult  to  obtain,  and  two  accountants  may  derive 
different  results,  but  each  is  seeking  the  same  result  work- 
ing along  the  same  lines  and  their  results  can  be  checked 
in  most  cases.  The  same  is  true  of  replacement  costs. 
In  most  cases  two  experienced  engineers  will  agree  with 
reasonable  accuracy  upon  the  replacement  cost  of  the 
physical  plant.  The  principles  to  be  employed  in  deter- 
mining overhead  charges  and  the  intangible  values  must 
be  formulated  so  carefully  that  there  can  be  little  or  no 
possibility  of  controversy  as  to  the  total  replacement 
cost. 

Likewise  the  loss  in  value  of  the  property  due  to  age, 
that  is  to  say  the  depreciation  of  the  property,  should  not 
be  subject  to  controversy,  provided  it  is  determined  by 
experts  familiar  with  the  art  employed  by  the  utility, 
with  the  condition  or  age  of  the  perishable  property  and 
with  the  fundamental  principles  relating  to  depreciation. 
The  same  is  true  of  the  other  figures  which  experts  must 
develop  and  present  to  the  tribunal. 

16.  Necessity  of  presenting  all  figures  indicative  of 
possible  present  value.  —  The  difficulty  of  obtaining 
original  cost  in  the  cases  of  many  of  the  older  and  larger 
undertakings  has  tended  to  cause  this  item  representative 
of  value  to  be  neglected.  In  fact,  in  very  many  cases 
of  valuation,  the  entire  efforts  of  the  appraisers  appear 
to  have  been  concentrated  upon  a  determination  of  the 
reproduction  cost-new  at  the  present  time,  even  in  some 
cases  neglecting  entirely  the  depreciation  in  the  value  of 
the  property  which  has  resulted  from  its  years  of  serv- 
ice. As  will  be  seen  later,  cost-new  at  the  date  of  the 
appraisal  cannot  be  accepted,  in  many  cases,  as  a  proper 
criterion  of  value,  at  least  theoretically.  Moreover,  no 
practical  business  man  would  accept  as  reliable  a  figure 
purporting  to  represent  value  which  gave  no  indication 


PROPERTY  VALUATIONS  17 

of  the  earning  capacity  of  the  property.  All  of  the  sets 
of  figures,  —  which  have  been  noted  above  and  will  be 
considered  more  carefully  in  later  portions  of  this  trea- 
tise, —  should  be  presented,  for  what  they  may  be  worth, 
to  the  tribunal  whose  duty  it  is  to  give  to  each  what  may 
seem  to  be  its  proper  importance  as  evidence  of  a  fair 
present  value. 


CHAPTER  II 

REPLACEMENT  COSTS  OF  PHYSICAL  PROPERTY 

17.  Definition  of  replacement  cost. 

18.  Present  or  original  conditions. 

19.  General  assumptions  as  to  replacement. 

20.  New  plant  identical  with  old  or  one  of  modern  design. 

21.  Effect  upon  replacement  cost  of  increased  difficulty  in  placing  plant. 

22.  Period  of  construction. 

23.  Unit  costs. 

24.  Mean  unit  costs  developed  from  curves  showing  trend   of   market 

prices. 

25.  Use  of  weighted  mean  prices  during  period  of  construction. 

26.  Piecemeal  v.  wholesale  construction. 

27.  Piecemeal    construction.     Effect   of   changes   and    enlargements   on 

cost. 

28.  Pavement  over  construction. 

17.  Definition  of  replacement  cost.  —  The  replacement 
cost  of  a  plant  may  be  defined  as  the  sum  of  money  which 
would  have  to  be  expended  at  the  present  time  to  con- 
struct a  plant  similar  in  all  respects  to  that  which  is 
already  in  service. 

Replacement  cost  is  the  cost  to-day  of  a  plant  substan- 
tially identical  with  that  which  is  in  use  and  useful  to  the 
public  at  the  time  of  the  appraisal. 

Replacement  cost,  or,  as  it  is  frequently  termed,  cost 
of  reproduction  or  cost-of-reproduction-new,  has  been 
given  various  meanings  in  the  past,  most  of  which  are 
due  to  an  attempt  to  make  replacement  cost  accord  with 
the  original  or  actual  cost.  Original  cost  and  replace- 
ment cost  must  be  entirely  divorced  from  each  other. 
If  the  original  cost  cannot  be  determined  from  the  books 
or  records  of  the  undertaking,  an  attempt  may  be  made 
to  derive  the  original  cost  by  studies  based  upon  past 


REPLACEMENT  COSTS  OF  PHYSICAL  PROPERTY       19 

prices  and  conditions,  but  the  replacement  cost  must  be 
the  cost  at  the  present  time  under  existing  conditions. 

18.  Present  or  original  conditions.  —  It  is  frequently 
argued  that  the  cost  of  reproduction  to-day  is  not  fair, 
in  many  instances,  to  those  who  constructed  the  property 
originally  under  more  adverse  conditions  than  would  be 
found  at  the  present  time.     This  difference  may  be  per- 
fectly true  but  such  increased  cost  would  be  included  in 
the  figures  representing  the  original  cost.     The  original 
cost  is  the  cost  under  past  conditions.     The  replacement 
cost  is  the  cost  under  existing  conditions.     There  may 
be  a  wide  divergence  between  these  two  figures,  but 
both  are  presented    to    the  court    or  commission    and 
that  tribunal  will  decide  which  figure,  taken  in  connec- 
tion with  the  others  presented  to  show  present  value, 
will  represent  most  nearly  the  true  and  fair  present  value. 

19.  General  assumptions  as  to   replacement.  —  Re- 
placement cost  of  a  plant  cannot  be  determined  without 
making   certain  general  assumptions  which   are   funda- 
mental to  the  entire  work  of  an  appraisal.     It  is  impor- 
tant that  these  assumptions  should  be  fully  recognized 
and  so  defined  that  all  appraisals,  by  whomsoever  made, 
should  follow  as  far  as  possible  the  same  methods.     In 
determining  the  replacement  cost  of  a  plant  the  follow- 
ing assumptions  must  be  made: 

1.  That  it  is  perfectly  possible  at  the  present  time  to 
construct  a  similar  new  plant  in  the  same  position  as 
that  occupied  by  the  plant  now  in  existence  and  under 
process  of  valuation. 

2.  That  the  new  plant  can  be  constructed  in  some 
definite  period  of  time. 

3.  That  the  fair  present  costs  can  be  obtained  for  the 
land,  material  and  labor  used  in  the  plant. 

The  first  of  these  assumptions  involves  two  questions, 
—  one,  shall  the  replacement  cost  be  figured  upon  new 


20  PUBLIC  UTILITIES 

plant  identical  in  all  respects  with  that  in  existence  or 
upon  new  plant  of  modern  design;  the  other,  can  a  new 
plant  be  placed  where  there  is  an  older  one  existing. 

20.  New  plant  identical  with  old  or  one  of  modern 
design.  —  It  has  been  contended  that  the  replacement 
cost  of  a  plant  should  be  that  which  it  would  cost  to  con- 
struct a  new  plant,  modern  in  all  respects  and  capable  of 
furnishing  the  same  service  as  that  afforded  by  the  older 
plant  then  under  investigation.  In  other  words,  what  it 
would  cost  a  competitor  to  build  a  new  and  up-to-date 
plant  of  the  same  size  and  furnishing  the  same  service. 
The  fallacy  of  this  argument  is  apparent  when  it  is  re- 
membered that  the  valuation  is  made  for  the  purpose  of 
finding  the  present  value  of  existing  property.  The  re- 
placement cost  is  one  of  the  figures  presented  to  show  the 
cost-new  of  that  property  and  from  such  cost-new  must 
be  deducted  the  depreciation  which  the  property  has 
suffered  from  its  years  of  use.  If  the  replacement  cost 
should  be  made  to  show  the  cost-new  of  a  different  prop- 
erty, made  up  of  units  different  either  in  size  or  in  charac- 
ter, it  would  be  utterly  impossible  to  determine  with  any 
approach  to  accuracy  the  present  value  of  the  existing 
property. 

It  is  true  that  the  rule  as  to  identical  plant  should  not 
be  carried  out  too  rigidly.  Some  units  of  plant  may  be 
no  longer  manufactured  and  could  not  be  obtained,  at 
the  present  time,  without  abnormal  cost.  In  such  cases 
the  purpose  of  the  appraisal  would  be  carried  out  more 
accurately  and  more  satisfactorily  by  using  the  cost  of 
the  nearest  modern  substitute. 

This  line  of  reasoning  appears  to  be  that  which  has 
prevailed  generally  in  valuations  made  in  the  United 
States.  The  Wisconsin  Commission  has  said: 

"From  the  facts  we  have  so  far  obtained,  the  indications 
are  that,  in  this  state  at  least,  the  instances  are  not  very  nu- 


REPLACEMENT  COSTS  OF  PHYSICAL  PROPERTY      21 

merous  where  the  inventory  and  construction  of  the  established 
plants  can  not  be  followed  with  a  reasonable  degree  of  safety."  1 

The  Courts  of  the  State  of  Maine  in  cases  involving 
the  valuation  of  water  works  have  favored  valuations 
based  upon  plants  identical  with  those  found  in  service. 

"  We  think  the  inquiry  along  the  line  of  reproduction  should, 
however,  be  limited  to  the  replacing  of  the  present  system  by 
one  substantially  like  it.  To  enter  upon  a  comparison  of  the 
merits  of  different  systems  —  to  compare  this  one  with  more 
modern  systems  —  would  be  to  open  a  wide  door  to  speculative 
inquiry,  and  lead  to  discussions  not  germane  to  the  subject. 
It  is  this  system  that  is  to  be  appraised,  hi  its  present  condi- 
tion and  with  its  present  efficiency."  2 

21.  Effect  upon  replacement  cost  of  increased  diffi- 
culty in  placing  plant.  —  Clearly,  a  new  plant,  built  at 
the  present  time  by  a  competitor,  for  example,  designed 
to  furnish  the  public  with  the  same  service,  would  in 
many  cases  be  much  more  expensive  to  place  than  was  the 
case  when  the  older  plant  was  constructed.  As  an  illus- 
tration, the  case  of  the  subway  plant  of  a  telephone  com- 
pany may  be  taken.  In  many  cases  in  large  cities  the 
system  of  underground  ducts  and  conduits  was  built  at 
such  an  early  date  that  relatively  few  obstructions  were 
met  as  compared  with  what  would  be  found  at  the  pres- 
ent time.  A  new  plant  would  be,  therefore,  much  more 
expensive  to  construct.  The  contention  could  be  made 
that,  as  the  streets  are  so  filled  at  the  present  time  with 
underground  pipes  of  various  kinds  including  the  con- 
duit system  under  appraisal,  the  replacement  cost,  due 
to  this  fact  alone,  would  be  very  much  greater  than  the 
original  cost.  Replacement  presupposes  the  non-exist- 
ence of  the  present  plant,  and  that  no  more  obstructions 
would  be  met  at  the  present  time  than  probably  were 

1  Wis.  R.  R.  Com.  Rpts.,  Vol.  3,  p.  637. 

2  Kennebec  Water  Dist.  v.  City  of  Waterville,  54  Atl.,  p.  19. 


22  PUBLIC  UTILITIES 

found  when  the  original  plant  was  constructed.  The 
replacement  cost,  therefore,  must  be  based  upon  a  con- 
duit of  the  same  size  and  character  situated  in  the  exact 
position  occupied  by  the  present  structure.  If  it  were 
ruled  that  the  value  of  the  present  conduit  was  what  it 
would  cost  to  place  a  new  one  wherever  space  could  be 
found  at  the  present  time  for  it  in  the  streets,  then  the 
present  conduit  would  prove  an  obstacle  to  the  new  and 
be  itself  a  means  of  enhancing  its  own  value,  which  is 
manifestly  an  absurdity.  This  contention  has  been 
fairly  met  in  the  Enid  case,  where  the  ruling  of  the  Court 
was  that,  - 

"The  plant,  in  our  opinion  in  arriving  at  its  cost  of  repro- 
duction new,  should  not  be  considered  as  an  existing  obstruc- 
tion upon  the  streets  which  would  have  to  be  worked  around  in 
constructing  a  new  plant  of  a  similar  kind."  1 

The  case  of  land  may  be  cited  as  another  illustration 
of  this  condition.  An  undertaking  in  acquiring  the  land 
needed  for  its  operation  may  have  been  obliged,  in  many 
cases,  to  purchase  the  buildings  found  upon  the  land  and 
to  remove  them  as  unsuitable  for  their  future  needs.  The 
original  cost  of  the  land  was  enhanced  by  the  then  value 
of  the  buildings  and  the  expense  which  was  incurred  in 
their  removal.  In  many  cases  the  undertaking  may  have 
constructed  special  and,  possibly,  very  expensive  build- 
ings suitable  for  its  needs.  In  determining  the  fair  pres- 
ent value  of  the  land  it  would  not  be  proper  to  enhance 
the  value  of  the  land  at  the  date  of  the  appraisal  by  the 
cost  of  the  present  buildings  and  by  the  cost  of  removing 
them.  In  other  words,  it  cannot  be  considered  as  an  "  ex- 
isting obstruction  ...  in  constructing  a  new  plant  of 
a  similar  kind."  The  method  to  be  followed  in  dealing 
with  such  a  case  will  be  considered  later. 

1  Supreme  Court  of  State  of  Oklahoma,  Pioneer  Tel.  &  Teleg.  Co.  v. 
E.  H.  Westenhaver  et  al.,  118  Pac.  354  (1911). 


REPLACEMENT  COSTS  OF  PHYSICAL  PROPERTY      23 

22.  Period  of  construction.  —  The  replacement  cost 
is  an  estimate  of  the  cost  of  reconstruction  at  the  present 
time  of  a  plant  identical  with  one  in  existence.  It  is 
impossible  to  make  such  an  estimate  without  a  definite 
assumption  as  to  the  time  that  will  be  required  to  bring 
together  the  materials  needed  and  to  perform  the  work 
necessary  in  placing  the  materials  in  the  plant  and  fitting 
the  plant  for  operation.  It  is  impossible  to  conceive  of 
the  replacement  of  the  plant  of  a  large  public  utility  as 
of  a  certain  day.  Time  and  usually  much  time  before  or 
after  the  date  assigned  for  the  valuation  would  be  required 
in  replacing  such  a  plant. 

The  question,  therefore,  to  be  decided  in  each  partic- 
ular case  is  what  length  of  time  should  be  allowed  for 
the  construction  period.  The  period  of  construction  is 
clearly  the  time  from  the  inception  of  the  undertaking 
up  to  the  time  when  the  plant  is  turned  over  to  the  oper- 
ating forces  and  is  put  into  service.  The  point  to  be 
settled  appears  to  be  whether,  in  determining  replace- 
ment costs,  the  entire  present  plant  must  be  constructed 
and  turned  over  as  a  complete  plant,  equal  in  size  to  that 
under  valuation,  or  whether  the  hypothetical  replacing 
plant  shall  be  constructed  piecemeal,  in  parts  as  large 
as  may  have  been  or  would  be  built  in  a  reasonable  and 
practical  construction  of  a  new  and  similar  plant. 

As  already  stated,  much  time  would  be  required  in 
building  a  plant  as  large  as  that  of  most  large  utilities,  a 
telephone  company  for  example.  In  a  recent  investiga- 
tion as  to  the  time  which  would  be  required  to  replace  a 
telephone  plant  of  fair  size,  about  300,000  stations,  experts 
have  testified  that  it  would  take  about  seven  years  to 
make  the  necessary  surveys  for  the  new  plant,  obtain  the 
required  material  and  construct  the  plant.  Moreover, 
that, 


24  PUBLIC  UTILITIES 

"It  would  be  probably  four  or  five  years  before  he  could 
take  on  any  subscribers  at  all,  and  after  that  period  he  could 
commence  joining  up  on  such  exchanges  as  were  ready."  .  .  . 
"If  the  work  is  to  be  done  in  a  thoroughly  efficient  manner  it 
ought  to  take  that  time.  Hurried  work  as  a  rule  is  not  satis- 
factory work."  l 

There  can  be  no  reasonable  question  that,  to  construct 
a  telephone  plant  costing  $50,000,000.00  or  more,  an  ex- 
penditure at  an  average  rate  of  more  than  $10,000,000.00 
a  year  would  not  be  possible  if  the  work  is  to  be  well  done. 
It  must  be  definitely  understood  that  these  fi'gures  are 
based  on  the  supposition  that  the  conditions,  under  which 
the  new  plant  is  supposed  to  be  constructed,  are  no  pres- 
ent plant,  no  engineering  plans,  no  organization  either 
in  headquarters  or  in  the  field.  There  is  every  reason 
for  feeling  that  a  period  of  construction  of  five  years  for 
a  plant  of  such  size  is  conservative  and  fair. 

In  the  case  of  the  construction  of  water  works,  it  has 
been  stated: 

"The  period  and  rate  of  construction  of  any  comparative 
plant  will  be  determined  by  the  ability  to  plan  and  build  wisely 
and  economically.  Experience  has  shown  that,  except  in  cases 
where  the  work  is  so  scattered  as  to  make  possible  its 
subdivision  into  a  large  number  of  contracts,  the  annual  expend- 
iture of  a  sum  in  excess  of  $1,000,000.00  is  not  an  easy  matter."  2 

The  two  above  cases  are  given  as  an  illustration  of  the 
line  of  reasoning  which  must  be  followed  in  each  partic- 
ular case  in  determining  the  period  of  construction,  that 
is  the  period  of  time  between  the  initiation  of  the  work 
and  the  completion  of  a  structure  identical  with  that  in 
existence. 

It  does  not  seem  reasonable  to  contend  that  no  por- 

1  Sir  John  Gavey's  Testimony  before  Select  Committee  on  Post  Office, 
1905  —  Report  pp.  37  &  39. 

2  Leonard  Metcalf  and  John  W.  Alvord,  Proc.  Am.  Soc.  Civil  Engi- 
neers, Vol.  37,  p.  165. 


REPLACEMENT  COSTS  OF  PHYSICAL  PROPERTY      25 

tion  of  the  replacing  or  comparative  plant  can  be  put 
into  service  until  the  entire  plant  has  been  completed, 
that  is  to  say,  until  the  end  of  the  construction  period. 
It  is  not  the  way  the  original  plant  was  constructed  nor 
would  any  new  undertaking  contemplate  such  a  plan. 
On  the  contrary,  every  effort  would  be  made  by  the  man- 
agement to  get  such  portions,  as  could  be  completed, 
into  service  at  as  early  a  date  as  possible.  The  result  of 
this  is  that,  for  portions  of  the  plant,  the  period  of  con- 
struction is  less  than  the  period  of  construction  of  the 
plant  as  a  whole.  The  time  of  construction  is  one  of  the 
most  important  assumptions  which  must  be  made  in  a 
determination  of  replacement  costs.  It  enters  as  an  im- 
portant consideration  in  a  decision  of  the  unit  costs, 
interest  during  construction  and  other  factors  entering 
as  a  portion  of  the  work  of  valuation. 

23.  Unit  costs.  —  In  forming  a  decision  on  this  ques- 
tion, the  real  object  of  the  investigation  must  be  kept 
constantly  in  mind:  it  is  to  determine,  with  the  least 
possibility  of  controversy,  what  it  would  cost  at  the  pres- 
ent tune  to  construct  a  plant  substantially  identical  with 
that  in  existence  and  similarly  placed.  It  is  easily  con- 
ceivable that  a  large  plant  could  not  be  constructed  in  a 
relatively  short  period  of  time  without  producing  an 
abnormal  increase  in  cost  due  to  the  unusual  demand  for 
labor  and  material.  It  is  clear  that  any  such  abnormal 
enhancement  in  cost  would  be  contrary  to  the  purpose  of 
the  investigation.  It  seems  clear,  therefore,  that  quo- 
tations as  of  a  special  day  for  all  of  the  units  of  a  plant 
would  not  be  a  satisfactory  method  of  obtaining  the 
costs  to  be  used  in  a  valuation.  On  this  question  the 
Wisconsin  Commission  has  ruled: 

"Average  or  normal  costs,  however,  are  not  always  easily 
determined,  and  this  for  the  reason  that  the  prices  of  the  vari- 
ous elements  that  enter  into  this  cost  vary  very  greatly  from 


26  PUBLIC  UTILITIES 

time  to  time.  Plants  built  when  the  prices  of  material,  labor 
and  other  elements  are  high  will  cost  much  more  than  if  con- 
structed when  these  prices  are  lower.  In  the  case  of  the  orig- 
inal cost  of  construction  of  plants  which  have  been  extended 
from  year  to  year,  such  fluctuations  in  prices  are  apt  to  be  of 
less  importance  because  the  additional  cost  of  extensions  made 
when  prices  were  high  are  likely  to  be  offset  by  lower  costs  for 
extensions  made  when  prices  were  lower.  In  the  case  of  the 
cost  of  reconstruction  the  effect  is  apt  to  be  greater.  If  this 
cost  is  figured  on  the  prices  which  prevailed  at  the  time  of  the 
appraisal,  it  may  differ  greatly  from  the  cost  that  would  have 
been  obtained  from  the  prices  that  prevailed  either  a  short 
time  previously  or  a  few  months  later,  as  well  as  from  the 
cost  that  would  have  been  obtained  from  average  prices. 
Owing  to  these  variations  cost-values  based  on  prices  as  of  the 
date  of  appraisal  would  not  seem  to  be  equitable  for  either 
rate-making  or  condemnation  purposes.  In  order  to  be  fair 
for  the  former  purpose  it  is  more  than  likely  that  the  rates 
would  have  to  be  changed  with  every  change  in  prices  and  con- 
sequently in  the  cost,  and  such  changes  would  not  only  be  im- 
practicable but  contrary  to  public  policy,  which  ordinarily 
requires  the  greatest  possible  stability  in  the  rates.  In  the 
latter  case  they  might  result  in  either  abnormal  losses  or  abnor- 
mal gains  to  those  from  whom  the  property  was  taken.  While 
there  may  be  something  to  be  said  in  favor  of  using  the  prices 
which  prevail  at  the  date  of  the  appraisal  in  computing  costs, 
it  appears  that  when  taken  as  a  whole  present  prices  for  these 
purposes  are  much  less  satisfactory  and  equitable  than  aver- 
age or  normal  prices.  What  is  thus  true  for  the  cost  of  the 
physical  plant,  may  also,  to  some  extent,  be  true  of  the  cost  of 
building  up  its  business."  1 

The  most  definite  ruling  on  this  subject  is  probably 
that  of  the  Maine  Courts  relative  to  the  valuation  of  water 
companies.  This  ruling  is  that  present  costs  shall  be 
based  on  "  prices  prevailing  at  a  time  in  advance  of  or 
prior  to  the  date  of  taking,  corresponding  to  the  probable 
period  of  construction." 

1  Wis.  R.  R.  Com.  Rpts.,  Vol.  3,  p.  624.  See  Cedar  Rapids  Gas  Light 
Co.  v.  City  of  Cedar  Rapids,  120  N.  W.  966  (1909). 


REPLACEMENT  COSTS  OF  PHYSICAL  PROPERTY      27 

This  ruling  defines  a  method  which  is  logical,  reasonable 
and  fair.  It  would  seem,  therefore,  that,  for  an  appraisal 
made  at  or  prior  to  the  date  of  taking,  the  mean  costs  of 
labor  and  material  entering  into  the  plant  during  a  period 
in  the  past  equal  to  the  construction  period,  as  above 
defined,  should  be  used  as  the  fair  present  cost. 

As  a  matter  of  interest,  the  methods  of  determining 
fair  present  costs  which  have  been  used  in  some  of  the 
largest  appraisals  made  in  this  country  are  given  below :  — 

In  appraisals  of  railway  property  made  for  the  State  of 
Michigan,  "the  basis  of  unit  prices  varied  somewhat  according 
to  circumstances.  The  underlying  principle  appears  to  have 
been  to  use  the  average  prices  for  a  term  of  years  for  such  com- 
modities and  items  of  property  as  had  been  and  would  prob- 
ably continue  to  be  subject  to  large  fluctuations  in  market 
prices;  as,  for  example,  the  price  of  copper  wire,  which  was 
taken  as  an  average  of  the  market  quotations  for  the  preced- 
ing seven  years,  and  the  price  of  the  steel  rails,  which  was  taken 
as  an  average  of  the  prices  for  the  preceding  ten  years.  .  .  . 
Other  items  of  property,  not  subject  to  extreme  fluctuations 
within  brief  periods  of  time,  current  prices  were  adopted."  l 

The  Wisconsin  Commission  has  adopted  "a  five-year  average 
basis  for  unit  prices  as  far  as  consistent  with  circumstances."  * 

The  Texas  Railroad  Commission  in  a  valuation  made 
by  them  in  1903  of  the  property  of  the  railroads  within 
that  State  used  costs  based  on  current  market  prices. 

A  valuation  of  the  railroad  property  in  the  State  of 
Washington  made  use  of  unit  costs  based  upon  prevailing 
prices  of  material. 

24.  Mean  unit  costs  developed  from  curves  showing 
trend  of  market  prices.  —  In  order  to  obtain  an  accurate 
estimate  of  replacement  cost,  there  is  need  of  figures 
showing  normal  prices  of  material  and  labor  at  the  pres- 
ent time  or  during  a  time  in  the  past  equal  to  the  period 
of  construction.  There  can  be  no  doubt  that  quotations 

1  Wis.  R.  R.  Com.  Rpts.,  Vol.  5,  p.  231  (1910). 


28  PUBLIC  UTILITIES 

as  of  one  day  for  all  of  the  material  required  for  the 
replacement  of  the  plant  of  a  large  utility  would  be  unfair 
and  would  give  no  indication  whatever  of  the  normal 
prices  which  are  required  in  estimating  the  replacement 
cost.  On  the  other  hand,  even  the  prices,  which  have 
prevailed  in  the  past  during  a  period  equal  to  the  period 
of  construction,  may  have  been  so  influenced  by  market 
conditions  as  not  to  afford  a  perfectly  fair  mean  cost  for 
use  in  a  valuation.  This  condition  is  very  conspicuously 
presented  in  the  case  of  copper.  The  market  fluctua- 
tions of  copper  have  been  such  that  wide  variations  in 
the  unit  costs  for  that  material  would  be  found  depending 
upon  the  date  and  length  of  the  period  of  construction. 

To  eliminate  as  far  as  possible  such  market  fluctuations 
and  obtain  the  normal  prices  as  of  the  present  time,  the 
prices  which  have  prevailed  in  the  past  for  material 
subject  to  wide  market  fluctuations  have  been  plotted. 
By  drawing  a  line  between  the  high  and  low  prices  such 
as  will  represent  a  fair  mean  price,  it  is  possible  to  deter- 
mine a  figure  freed  from  market  irregularities.  This 
method  has  been  employed  by  the  Wisconsin  Commission 
in  several  recent  cases 1  as  a  means  of  checking  the  accu- 
racy of  figures  obtained  by  the  use  of  the  mean  prices 
during  a  period  of  construction,  usually  assumed  by  that 
Commission  as  five  years.  It  is  a  method  which  should 
be  used  as  a  check,  at  least,  for  all  material  subject  to 
wide  variations  due  to  market  conditions. 

25.  Use  of  weighted  mean  prices  during  period  of 
construction.  —  In  one  or  more  important  valuations, 
claims  have  been  made  for  costs  of  material  based  on  the 
weighted  mean  costs  of  material  purchased  by  the  under- 
taking in  the  past  during  a  period  equal  to  the  assumed 
period  of  construction.  It  was  claimed  that  higher 

1  Wis.  R.  R.  Com.  Vol.  7,  p.  84  (1911).    Cast  iron  water  pipe. 
See  also  Floy,  Valuation  of  Public  Utilities,  p.  65. 


REPLACEMENT  COSTS  OF  PHYSICAL  PROPERTY      29 

prices  for  material  and  labor  are  found  usually  at  times 
of  greatest  industrial  activity  and,  as  a  consequence,  the 
money  expended  by  the  undertaking  could  not  be  meas- 
ured by  the  mean  of  the  prices  alone.  These  prices  should 
be  weighted,  it  was  claimed,  by  the  amounts  of  material 
actually  paid  for  and  used  in  the  property  under  valuation. 

It  must  be  apparent  that  such  a  contention  is  hi  direct 
contradiction  to  the  principles  underlying  replacement 
costs  which  have  been  enunciated  in  the  preceding  sec- 
tions of  this  chapter.  It  may  have  cost  the  undertaking 
more  than  would  be  shown  by  the  replacement  cost 
based  on  mean  figures,  but  the  cost  to  the  undertaking 
is  indicated  by  the  figure  representing  original  cost. 
If  large  portions  of  the  plant  had  been  constructed  when 
prices  were  abnormally  high,  the  tribunal  weighing  the 
figures  showing  original  and  replacement  costs  may  give 
such  weight  as  it  deems  proper  to  that  fact  as  revealed 
by  the  original  cost  figure.  But  the  replacement  cost 
must  be  evolved  from  prices  based  on  mean  normal  costs, 
as  of  the  present  time,  without  reference  in  any  way  to 
what  may  have  been  done  by  the  undertaking  in  the  past. 

Moreover,  if  such  a  contention  were  accepted,  it  would 
be  recognizing  a  figure  based  upon  prices  paid  for  only  a 
portion  of  the  plant,  that  portion  built  within  the  period 
of  construction.  In  many  cases  this  would  represent  only 
a  fraction  of  the  entire  plant. 

26.  Piecemeal  v.  wholesale  construction.  —  In  almost 
every  appraisal  the  question  arises  as  to  whether  the 
costs,  principally  of  labor  and  transportation  of  men  and 
material,  should  be  based  upon  what  it  would  cost  to 
replace  the  plant  in  a  wholesale  manner  or  whether  the 
plant  should  be  considered  as  being  rebuilt  portions  at 
a  time,  substantially  in  the  same  manner  as  the  original 
plant  was  built.  This  difference  can  be  made  clear  by  a 
consideration  of  one  or  two  practical  cases. 


30  PUBLIC  UTILITIES 

In  practice,  underground  cables  in  a  telephone  system 
are  drawn  into  a  conduit  one  at  a  time  as  the  demands  of 
the  business  may  require.  The  entire  underground  cable 
system  has  been  built  in  this  manner,  and  definite  knowl- 
edge has  been  obtained,  as  the  result  of  large  experience, 
as  to  the  cost  of  laying  and  splicing  cables  in  this  man- 
ner. At  the  present  time  there  will  be  found  a  large 
number  of  cables  in  a  given  manhole,  running  between 
that  manhole  and  the  next.  It  is  manifest  that  it  would 
be  less  expensive  with  the  construction  men  and  material 
at  a  manhole  to  draw  in  all  of  the  cables,  rather  than  to 
bring  the  men  and  material  necessary  for  the  drawing  in 
operation  to  that  point  to  draw  in  one  cable  alone.  Again, 
there  may  be  a  thousand  telephone  stations  in  one  large 
office  building;  clearly  it  would  be  a  matter  of  less  cost 
to  install  and  connect  all  of  these  stations  as  one  opera- 
tion rather  than  to  place  them  practically  one  at  a  time, 
in  the  manner  that  the  original  system  was  constructed. 

Before  entering  upon  a  discussion  of  this  question,  it 
is  important  to  emphasize  a  fact  which  has  been  touched 
upon  already  in  section  22.  In  determining  replacement 
cost  the  appraiser  must  not  assume  that  he  has  definite 
plans  and  information  as  revealed  by  the  inventory  of 
the  kind  and  position  of  each  unit  of  plant.  If  this 
assumption  were  made  there  would  be  a  usurpation  of 
property  of  the  undertaking  which  it  had  cost  the  under- 
taking much  time  and  expense  to  obtain.  Replacement 
assumes  the  rebuilding  of  a  plant  of  the  same  size  and 
composed  of  the  same  units  placed  substantially  in  the 
same  positions  as  in  the  existing  plant,  but  a  knowledge 
of  what  kind  of  units  and  of  their  position  would  have  to 
be  acquired  through  the  labor  and  skill  of  an  engineer 
and  with  a  public  demand  similar  to  that  which  had  been 
met  in  the  past  by  the  existing  company.  The  theory  of 
replacement  costs  would  not  be  complied  with  and  there 


REPLACEMENT  COSTS  OF  PHYSICAL  PROPERTY      31 

would  be  manifest  injustice  to  the  undertaking,  if  the  in- 
ventory of  the  plant  of  that  undertaking  was  turned  over 
to  a  contractor  and  the  figure,  which  he  might  give  as  the 
cost  of  replacing  the  plant,  used  as  the  replacement  cost. 
Replacement  cost  is  the  normal  present  cost.  Prac- 
tically no  large  utility  has  ever  been  constructed  whole- 
sale and  such  a  method  would  be  clearly  abnormal.  It  is 
true  that  assumptions  have  been  made  as  to  a  construc- 
tion period  much  shorter  than  the  normal  period  of  growth 
of  most  utilities,  but  the  period  chosen  has  not  been  one 
which  necessarily  required  wholesale  work.  There  should 
be  nothing  inconsistent  in  an  assumption  of  piecemeal 
construction  and  such  definite  and  reasonable  periods  of 
construction  as  have  been  suggested.  Normal  costs 
of  construction  work  can  be  obtained  from  reports  as  to 
the  cost  of  work  performed  under  usual  and  customary 
conditions.  It  would  be  difficult  and  many  inaccuracies 
would  probably  result  if  an  attempt  were  made  to  develop 
costs  on  a  wholesale  method  of  reconstruction.  There 
seems  to  be  every  reason  in  logic  and  equity  for  the 
adoption  of  costs  based  on  piecemeal  construction  in  a 
determination  of  the  replacement  cost  of  a  plant. 

The  Wisconsin  Commission  agree  in  this  and  say  that, 
"In  appraising  utilities  which  have  been  constructed  on  this 
basis,  the  problem  seems  to  be  to  find  units  of  cost  that  repre- 
sent a  fair  average  of  these  conditions.  To  find  such  units 
appears  to  be  practicable.  In  fact,  it  would  seem  that  the 
extra  costs  of  piecemeal  construction  can  be  more  readily  and 
accurately  taken  into  account  in  this  manner  than  by  an  arbi- 
trary allowance  of  a  lump  sum  to  be  added  to  a  cost  that  has 
originally  been  computed  upon  the  basis  of  continuous  con- 
struction." l 

The  two  illustrations  given  above  represent  extreme 
cases.     As  a  practical  matter,  for  a  very  large  portion  of 

1  Wis.  R.  R.  Com.  Rpts.,  Vol.  4,  pp.  548-549. 


32  PUBLIC  UTILITIES 

most  public  service  plants,  the  question  of  piecemeal 
or  wholesale  construction  does  not  enter  as  an  important 
consideration,  for  the  reason  that  it  is  usual  to  construct 
portions  of  the  plant  on  a  scale  sufficiently  large  to  make 
the  difference  between  piecemeal  and  wholesale  construc- 
tion negligible. 

27.  Piecemeal  construction.  Effect  of  changes  and 
enlargements  on  cost.  —  The  above  reasoning  relative  to 
piecemeal  construction  must  not  be  carried  too  far.  The 
existing  plant  may  be  composed  of  units,  buildings  for 
example,  which  have  been  enlarged  to 'meet  the  growing 
demands  of  the  business;  because  the  total  cost  to  the 
undertaking  of  the  original  building,  plus  the  costs  of 
enlargement,  was  greater  than  what  it  would  cost  to 
replace  it  to-day  in  one  operation,  can  be  no  reason  for 
an  increased  replacement  cost  on  the  theory  of  piecemeal 
construction. 

It  has  been  contended  that  it  requires  the  greatest 
skill  of  the  management  and  of  the  engineer  to  determine 
for  what  length  of  time  in  the  future  a  plant  such  as  that 
required  for  a  public  utility  should  be  constructed.  If  a 
plant  is  constructed  initially  of  a  size  which  will  meet  the 
demands  of  the  public  many  years  in  the  future,  it  is 
necessary  for  the  public  in  the  intervening  years  to  pay, 
in  the  way  of  rates,  the  charges  upon  a  very  large  idle 
plant.  On  the  other  hand,  if  the  plant  is  constructed 
of  insufficient  size  it  will  have  to  be  reconstructed  or 
enlarged  at  frequent  intervals  at  a  much  greater  cost 
than  would  be  the  case  if  it  were  built  of  its  " ultimate" 
size  at  one  time.  In  other  words,  the  engineer  is  obliged 
to  balance  the  additional  cost  of  what  may  be  called 
piecemeal  construction  against  the  interest  charges  upon 
an  idle  plant. 

The  question  is,  therefore,  whether,  in  determining  the 
replacement  costs  of  a  plant,  these  increased  costs  which 


REPLACEMENT  COSTS  OF  PHYSICAL  PROPERTY       33 

have  been  wisely  incurred  by  building  the  plant  no  more 
rapidly  than  was  consistent  with  the  greatest  economy 
should  be  considered,  or  whether  the  replacement  cost 
should  be  construed  strictly  as  originally  defined,  that  is, 
the  sum  which  would  have  to  be  expended  at  the  present 
time  to  replace  a  plant  identical  with  one  already  in 
service:  whether  a  company  which  has  constructed  its 
plant  as  the  public  required  it,  and  has  so  timed  the 
periods  of  its  enlargement  that  the  total  expense  to  the 
company,  and  in  consequence  to  the  public,  has  been  kept 
at  a  minimum,  should  be  obliged  to  suffer  by  the  use  of 
unit  costs  of  replacement  built  up  on  what  may  be  called 
wholesale  construction  rather  than  by  piecemeal  con- 
struction of  the  plant. 

There  can  be  but  one  answer  to  this  question.  The 
replacement  cost  must  be  figured  upon  the  plant  as  it 
now  exists.  If  a  plant  unit  has  cost  more,  because  it 
has  been  enlarged,  than  it  would  cost  to  construct  it  anew 
as  it  now  stands,  such  increased  cost  must  be  due  in  a 
large  measure  to  a  virtual  rejection  of  some  material 
and  labor  which  formed  a  part  of  the  original  construc- 
tion. On  this  question  the  rulings  of  the  courts  are 
definite.  The  valuation  must  be  based  upon  the  plant 
as  it  is. 

28.  Pavement  over  construction.  —  Portions  of  the 
plants  of  many  public  utilities  are  placed  under  the 
highways.  In  some  instances  the  streets  have  been  paved 
after  the  underground  construction  had  been  installed, 
or  a  cheaper  grade  of  pavement  has  been  replaced  by  a 
more  expensive  kind.  In  such  cases  the  pavement  may 
have  cost  the  undertaking  relatively  nothing  but,  if  the 
underground  construction  had  to  be  replaced  at  the  pres- 
ent time,  there  would  be  considerable  expense  involved 
in  taking  up  and  replacing  the  pavement. 

It  has  been  contended  quite  generally  that  the  cost  of 


34  PUBLIC  UTILITIES 

paving  not  actually  paid  for  by  the  undertaking  at  the 
time  of  the  original  construction  should  not  be  made  a 
portion  of  the  replacement  cost.  Such  a  contention  if 
carried  out  is  subversive  of  the  fundamental  principles 
of  the  development  of  replacement  costs.  The  cost  of 
replacing  paving  found  over  underground  structures  must 
be  made  a  portion  of  the  replacement  cost. 

The  original  cost  will  show  properly  what  it  had  actu- 
ally cost  the  undertaking  to  construct  its  underground 
system  with  or  without  pavement.  The  replacement 
cost  is  what  it  would  cost  to-day  to  construct  a  new  plant 
similar  to  one  in  existence  and  similarly  placed.  If  the 
underground  system  was  found  under  paved  streets,  the 
replacement  cost  should  include  the  cost  of  taking  up  and 
replacing  the  pavement  of  the  particular  kind  found. 
The  replacement  cost  may  be  made  in  this  way  higher 
than  the  fair  present  cost,  or  it  may  not;  it  remains  for 
the  courts  to  determine  judicially  what  weight  shall  be 
given  to  these  two  sets  of  figures,  " original  cost"  and 
" replacement  cost,"  in  view  of  all  prevailing  conditions. 
Because  those  preparing  the  figures  to  show  what  it  would 
cost  to  build  a  new  and  similar  plant  feel  that  pavement 
not  paid  for  should  not  be  made  a  portion  of  the  true 
present  value  seems  an  insufficient  reason  for  presenting 
figures  which  do  not  represent  the  facts,  the  actual  replace- 
ment cost. 


CHAPTER  III 

DETERMINATION    OF   REPLACEMENT    COST 

29.  Inventory. 

30.  Plant  elements. 

31.  Costs. 

32.  Items  included  in  unit  costs. 

33.  Unit  costs  —  Costs  of  material. 

34.  Unit  costs  —  Costs  of  labor. 

35.  Unit  costs  —  Losses  on  tools  and  material. 

36.  Unit  costs  —  Insurance. 

37.  Overhead  charges  —  General  consideration. 

38.  Overhead    charges  —  Interest    during    construction.     General    con- 

sideration. 

39.  Overhead  charges  —  Interest  during  construction.     Mean  weighted 

time. 

40.  Overhead  charges  —  Interest  during  construction.    Rate  of  interest. 

41.  Overhead  charges  —  Engineering. 

42.  Overhead  charges  —  Organization  expense. 

43.  Overhead  charges  —  Legal  expense. 

44.  Overhead  charges  —  Contingencies. 

45.  Overhead  charges  —  Other  possible  costs. 

46.  Promotion  costs. 

47.  Sale  of  securities. 

48.  Contractor's  profit. 

49.  Overhead  charges  —  Method  of  application. 

50.  Real  estate. 

51.  Cost  of  land  affected  by  cost  of  hypothetical  buildings. 

52.  Cost  of  buildings 

29.  Inventory.  —  The  replacement  cost  has  been  de- 
fined as  the  "  amount  of  money  which  would  have  to  be 
expended  at  the  present  time  to  bring  into  existence  a 
property  substantially  identical  with  that  of  the  under- 
taking being  appraised."  In  order,  therefore,  to  obtain 
the  replacement  cost  of  the  physical  property  of  an  under- 
taking, a  knowledge  of  two  things  must  be  obtained,  - 
first,  a  knowledge  of  the  several  classes  of  property  of 
which  the  plant  is  composed  and  of  the  number  of  units 


36  PUBLIC  UTILITIES 

of  the  same  kind  in  use  in  each  of  these  classes;  second, 
a  knowledge  of  the  cost  of  each  unit  in  its  final  position  in 
the  plant. 

The  first  of  these  requisites  must  be  obtained  from  an 
inventory  of  the  entire  plant  made  by  an  actual  inspec- 
tion and  enumeration  of  each  unit  of  every  class  found 
in  service  or  held  in  reserve  as  useful  for  the  public  in 
furnishing  and  maintaining  a  uniform  and  uninterrupted 
service. 

The  second  must  be  obtained  by  a  determination  of  all 
costs  which  would  be  incurred  in  obtaining  similar  units 
of  each  class  and  placing  them  where  existing  units  are 
now  found  in  the  plant. 

The  methods  to  be  employed  in  making  the  inventory, 
the  forms  to  be  used  and  the  system  to  be  employed  in 
handling  these  forms,  both  in  the  field  and  in  the  office, 
need  not  be  described  in  the  present  study.1 

30.  Plant  elements.  —  A  plant  element  is  a  definite 
class  of  property :  thus,  —  iron  wire,  copper  wire,  road 
bed,  bridges,  poles,  are  each  elements  of  a  plant.  But  in 
the  case  of  most  large  public  utility  plants,  the  number 
of  different  articles  or  other  character  of  property  is  so 
great  that  an  inventory  showing  them  all  would  be  too 
cumbersome  to  be  capable  of  use.  Thus,  in  an  inven- 
tory of  the  property  of  a  telephone  or  telegraph  company, 
a  cross-arm  used  upon  a  pole  to  support  wires  has  upon 
it  a  number  of  pins  upon  which  the  line  insulators  are 
screwed,  each  pin  is  attached  to  the  cross-arm  by  a  nail, 
the  cross-arm  is  very  generally  fastened  to  the  pole  by  a 
bolt,  and  it  is  prevented  from  moving  in  a  vertical  plane 
by  the  use  of  cross-arm  braces  held  in  place  by  bolts  and 
a  drive  screw.  Each  one  of  the  articles  above  enumerated 
could  be  made  a  plant  element  and  recorded  by  those 
making  the  inventory  records  in  the  field,  upon  the  forms 

1  See  H.  E.  Riggs,  Proc.  Am.  Soc.  of  Civil  Eng.,  Vol.  XXXVI,  No.  9. 


DETERMINATION  OF  REPLACEMENT  COST     37 

prepared  for  their  use.  On  the  other  hand,  the  cross- 
arm  complete  in  place  with  all  associated  apparatus  could 
be  made  the  plant  element  and  all  cross-arms  of  standard 
form  and  supported  in  a  standard  manner  recorded, 
thereby  eliminating  the  vast  amount  of  field  and  office 
work  which  would  result  if  each  piece  of  associated  appa- 
ratus were  made  an  element  and  had  to  be  recorded 
individually. 

The  limitation  which  must  be  made  to  grouping  to- 
gether many  articles  into  one  plant  element  is  dependent 
upon  whether  the  several  articles  composing  the  unit 
are  brought  into  use  simultaneously  and  all  pass  out  of 
use  simultaneously  when  they  have  served  their  useful 
life.  In  the  case  cited  of  a  cross-arm,  when  the  cross- 
arm  is  placed  upon  a  pole  it  is  associated  with  all  of  the 
articles  above  enumerated.  When  a  cross-arm  has 
become  unserviceable  due  to  age,  it  is  removed  and 
destroyed  and  with  it  the  pins  and  nails  used  to  attach 
the  pins  to  the  cross-arm.  If  the  cross-arm  braces  and 
pole  bolts  and  other  hardware  used  with  them  can  be 
and  usually  are  used  again  with  a  new  cross-arm,  then 
these  articles  of  hardware  must  not  be  included  with  the 
cross-arm  and  pins  in  order  to  make  a  plant  element. 
This  distinction  is  needed  in  order  that  the  depreciation 
of  the  plant  can  be  more  readily  figured,  and  this  clearly 
will  be  the  case  when  the  plant  element  has  a  definite 
life. 

The  plant  element  is,  therefore,  an  article  or  group  of 
articles  used  in  such  close  association  in  the  plant  that 
they  are  normally  placed  in  service  and  removed  from 
service  together. 

31.  Costs.  —  It  has  become  the  custom  of  appraisers, 
in  assigning  costs  of  reproduction  to  the  plant  elements, 
to  divide  the  costs  of  such  construction  into  two  classes, 
unit  costs  and  overhead  charges. 


38  PUBLIC  UTILITIES 

The  cost  of  each  unit  of  the  plant  elements  in  its  final 
position  is  known  as  the  unit  cost.  The  unit  cost  includes 
all  expenses  to  which  an  undertaking  would  be  put  in  pur- 
chasing the  unit  and  placing  it  in  its  final  position  in  the 
plant.  It  includes,  however,  only  such  expenses  as  can 
be  definitely  assigned  to  the  units  of  the  plant  elements. 

There  are  many  other  expenses  of  a  more  general 
nature  which  cannot  be  assigned  readily  to  an  individual 
unit,  but  can  be  spread  more  accurately  over  the  cost  of 
the  plant  as  a  whole  or  over  certain  groups  of  plant 
elements.  Expenses  of  this  character  are  known  as  over- 
head charges  and  are  applied  usually  in  the  form  of  per- 
centages of  that  portion  of  the  replacement  cost  of  the 
physical  property,  obtained  by  the  application  of  unit 
costs  to  the  respective  number  of  units  of  all  elements 
found  in  the  plant. 

32.  Items  included  in  unit  costs.  —  The  entire  plant 
is  divided,  in  the  manner  above  described,  into  plant 
elements,  and  the  inventory  when  made  shows  the  num- 
ber of  units  of  each  element  found  in  service.  The  cost  of 
each  unit  of  the  plant  elements  in  its  final  position  is  known 
as  the  unit  cost,  and  is  composed  not  only  of  the  cost  of  the 
material  employed  but  of  all  other  items  of  expense  which 
are  necessarily  involved  in  the  purchase  of  the  articles  of 
which  it  is  composed,  of  getting  them  together,  assem- 
bling and  placing  them  in  their  final  position.  These  are 
all  costs  which  can  be  readily  assigned  to  each  article  or 
plant  unit  and  combined  to  form  the  unit  cost. 

The  several  items  of  cost  which  may  enter  to  form  the 
unit  cost  are,  — 

First  cost  of  article. 

Purchasing  cost. 

Transportation  from  factory  to  storehouse. 

Storehouse  cost,  rent,  light,  heat  and  clerical  work  at 
storehouse. 


DETERMINATION  OF  REPLACEMENT  COST  39 

Inspection. 

Assembling  or  fitting. 

Transportation  from  storehouse  to  town  where  used. 

Distribution  from  train  to  work. 

Labor  of  men  placing  the  element  in  position. 

Transportation  of  men  and  tools  to  work. 

Lost  time  of  men  during  travel  and  wet  weather. 

Losses  on  tools  and  material. 

Insurance,  liability  and  fire. 

Some  or  all  of  the  above  items  of  expense  are  present 
in  the  unit  cost  of  each  element.  They  can  all  be  deter- 
mined or  properly  apportioned  without  difficulty  for 
each  element. 

33.  Units  Costs  —  Costs  of  material.  —  The  first  cost 
of  the  unit  of  an  element  has  been  fully  discussed  and 
decided  to  be  the  mean  of  the  market  prices  which  have 
prevailed   during  the   assumed  period   of   construction. 
The  same  ruling  should  hold  as  to  the  several  elements 
of  cost  above  enumerated.     The  costs  of  labor,  freight 
and  transportation  during  a  period  in  the  past  equal  to 
the  assumed  period  of  construction  are  usually  equally 
obtainable  and,  by  the  use  of  such  figures,  a  consistent 
and  fair  present  cost  of  the  unit  can  be  obtained. 

34.  Unit  costs  —  Costs  of  labor.  —  In  the  determina- 
tion of  unit  costs,  as  above  explained,  not  only  is  the 
cost  of  the  material  included,  but  the  labor  and  expense 
involved  in  getting  the  material  to  its  position  in  the  plant, 
setting  it  in  place,  and  making  it  ready  for  service.     The 
question  arises  as  to  what  labor  charges  should  be  in- 
cluded in  these  unit  costs.     In  the  construction  of  a  plant 
there  is  always  incurred  the  expense  of  purchasing  the 
material,  getting  it  from  the  factory  to  the  stores,  ship- 
ping from  the  stores  into  the  field,  the  cost  of  the  labor 
of  the  superintendent  of  the  plant,  and  all  foremen  and 
sub-foremen,  the  time  and  travel  of  the  men  engaged 


40  PUBLIC  UTILITIES 

upon  the  field  work,  and  the  shipment  of  tools  and  mate- 
rial required  in  placing  the  element.  It  would  seem  that 
it  is  proper  and  right  to  charge  all  legitimate  expenses  of 
construction  as  a  portion  of  unit  costs  except  such  charges 
as  were  of  such  a  general  nature  as  cannot  be  assigned  to 
the  special  job  involved  in  placing  the  unit.  In  view  of 
this,  it  has  been  customary  to  include  in  the  unit  costs 
the  above  items  and  the  labor  charges  of  the  plant  men 
only  up  to  and  including  the  foreman  of  the  gang  espe- 
cially engaged  on  the  particular  work  involved.  The 
superintendent  of  the  plant  and  foreman  are  excluded,  as 
their  time  usually  is  so  spread  among  several  lines  of  work 
that  it  is  difficult,  if  not  impossible,  to  make  a  proper 
separation  and  determination  of  the  cost  of  their  ser- 
vices on  a  particular  job. 

35.  Unit  costs  —  Losses  on  tools  and  material.  —  In 
the  normal  construction  of  a  plant,  tools  must  be  used, 
and  these  tools  wear  out  and  must  be  replaced.  This 
item  is,  therefore,  a  necessary  and  usual  expense  which 
must  be  included  with  the  other  costs  in  finding  the 
replacement  cost  of  a  plant.  Again,  there  is  always  a 
certain  amount  of  false  work,  necessary  in  certain  classes 
of  construction,  which  will  not  be  found  by  an  inven- 
tory but  is  known  as  being  necessarily  incident  to  the 
construction.  The  same  is  true  of  a  certain  amount  of 
material  which  is  lost  or  broken  during  the  process  of 
construction. 

All  such  losses  are  usual,  inevitable,  well  known  and 
established  for  each  class  of  construction  work.  The 
tools  and  forms,  required  in  the  construction  and  pla- 
cing of  the  several  plant  elements,  differ  so  greatly  that  a 
figure  can  be  obtained,  to  properly  cover  this  item  of 
expense,  more  accurately  for  an  individual  element  than 
for  the  plant  as  a  whole.  The  same  general  considera- 
tions are  equally  true  for  the  expense  arising  from  the 


DETERMINATION  OF  REPLACEMENT  COST     41 

loss  of  material  bought  but  not  found  in  the  plant  at  the 
time  of  the  inventory. 

Losses  of  this  character  can  be  assigned  more  accurately 
as  a  portion  of  unit  costs,  therefore,  than  as  a  general 
expense,  difficult  of  allocation  and,  in  consequence,  made 
an  overhead  charge. 

36.  Unit   costs  —  Insurance.  —  All   authorities   agree 
that  the  expenditures  made  during  the  period  of  con- 
struction for  insurance  against  fire,  for  the  fidelity  of  its 
employees,  and  against  losses  due  to  injury  to  its  em- 
ployees or  others,  should  form  a  portion  of  the  capital 
expended  in  the  construction  of  the  plant.     This  item  is 
intended  to  cover  only  the  time  during  the  actual  con- 
struction work,  or  rather  until  such  time  as  the  new  plant 
is  turned  over  to  the  operating  forces.     Clearly  this  item 
of  expense  will  be  incurred  to  a  greater  or  less  degree 
depending  upon  the  character  of  the  element.     It  seems 
best,  therefore,  to  include  this  cost  as  a  portion  of  the 
unit  costs  rather  than  as  an  overhead  charge. 

37.  Overhead    charges  —  General:    consideration.  — 
Unit  costs  as  above  described  include  all  items  of  cost 
which  can  be  determined  and  definitely  attributed  to 
the  purchase  of  each  particular  unit  and  of  getting  it 
into  its  final  position  in  the  plant.     There  are  several 
other  items  of  cost  which  are  necessarily  incident  to  con- 
struction work  but  are  of  such  a  general  nature  that  they 
cannot  be  definitely  assigned  to  individual  units,  although 
they  are  indisputably  present  hi  the  construction  of  the 
plant  as  a  whole.     An  example  of  this  is  the  general 
supervision  of  the  construction  work.     The  labor  costs 
involved  in  placing  units,  as  found  for  the  unit  costs  and 
included  in  them,  were  those  up  to  the  gang  foreman, 
that  is  to  say  the  cost  of  labor  of  all  those  who  actually 
were  engaged  in  placing  the  units.     But,  there  were  over 
the  gang  foremen   superintendents,  local,   district    and 


42  PUBLIC  UTILITIES 

general,  all  of  whom  gave  a  portion  of  their  time  to  the 
construction  of  the  plant  and,  consequently,  indirectly 
a  portion  to  the  placing  of  each  unit.  It  is  impossible  to 
determine  and  assign  what  portion  of  their  time  and, 
consequently,  what  expense  should  be  attributed  to  the 
placing  of  each  unit.  It  is,  however,  a  simple  matter  to 
find  what  relation  their  salaries  and  expenses,  attribut- 
able to  construction  work  for  the  period  of  construction, 
bore  to  the  total  cost  of  construction.  Knowing  this  rela- 
tion, the  cost  of  construction  determined  by  means  of 
the  unit  costs  can  be  increased  by  a  definite  percentage 
to  cover  such  overhead  supervision.  Charges  of  this 
character  in  the  form  of  percentages  are  known  as 
" overhead  charges." 

Overhead  charges  have  been  recognized  and  used  in 
practically  all  large  inventories,  but  have  been  the  sub- 
ject of  much  controversy  and  discussion  due,  in  a  large 
measure,  to  a  lack  of  knowledge  and  proper  apprecia- 
tion, on  the  part  of  those  questioning  such  charges,  of 
what  factors  were  included  in  the  unit  costs  and  what 
were  omitted  from  such  costs  and  applied  as  portions 
of  the  overhead  charges.  In  what  was  said  relative  to 
unit  costs,  the  items  of  expense  which  are  to  be  included 
have  been  defined.  The  overhead  charges,  now  under 
discussion,  should  be  determined  in  percentages  of  plant 
cost  to  include  all  such  costs  of  construction  as  are  of 
such  a  general  nature  that  they  cannot  be  allocated  to 
any  individual  or  particular  piece  of  work. 

38.  Overhead  charges  —  Interest  during  construction. 
General  consideration.  —  In  presenting  this  subject, 
the  words  of  a  recent  decision  bearing  on  this  question 
will  be  quoted: 

"A  plant  "of  large  size  "  cannot  be  constructed  instantly. 
It  requires  time  to  assemble  the  physical  properties  and  still  a 
greater  length  of  time  to  put  these  units  into  place  where  they 


DETERMINATION  OF  REPLACEMENT  COST     43 

may  be  used  to  render  service.  During  this  period  the  cap- 
ital invested  must  of  necessity  be  idle  and  no  income  can  be 
derived  therefrom.  When  the  construction  of  the  plant  is 
completed,  no  willing  seller,  who  is  not  forced  to  sell,  would 
take  for  his  plant  the  cost  of  the  physical  units  and  the  cost 
of  the  labor  in  the  construction,  because  the  plant  has  cost 
him  in  addition  thereto  the  use  of  the  capital  or  a  certain 
part  thereof  invested  in  the  physical  properties  during  the 
time  of  construction.  A  willing  buyer  could  afford  to  pay 
and  would  pay  more  than  the  actual  cost  of  labor  and  mate- 
rial, assuming  that  the  plant  has  been  economically  constructed, 
because  such  cost  would  not  represent  the  total  expenditures 
the  purchaser  would  have  to  make  in  order  to  construct  the 
plant  himself.  In  addition  to  such  expenditures  he  would 
have  to  expend  the  earnings  of  his  capital  during  the  period 
of  construction.  No  case  has  been  cited,  and  in  our  inves- 
tigation we  have  found  no  case  involving  this  question  where 
a  reasonable  amount  has  not  been  considered  and  allowed  for 
loss  of  interest  during  construction  as  part  of  the  cost  of  con- 
struction." l 

The  loss  of  interest  during  the  construction  period  is 
dependent  in  each  special  case  upon  what  the  construc- 
tion period  has  been  determined  to  be,  following  the  line 
of  reasoning  described  in  the  preceding  chapter.  In 
some  cases  the  loss  of  interest  would  extend  throughout 
a  large  portion  of  the  construction  period. 

In  most  cases,  however,  such  portions  of  the  plant  as 
could  be  made  productive  most  quickly  would  be  built 
first  and  extensions  to  the  plant  made  with  the  same 
thought  in  mind.  Yet  even  when  a  plant  is  thus  con- 
structed in  a  rational  and  businesslike  manner,  there 
must  be  much  time  which  will  elapse  between  the  incep- 
tion of  the  undertaking  and  the  completion  of  the  first 
portion  of  the  plant.  The  money  required  to  build  the 
plant  must  be  in  hand  or  available  from  the  outset  up  to 

1  Supreme  Court  State  of  Oklahoma  —  Pioneer  Tel.  &  Tel.  Co.  v.  Wes- 
tenhaver  et  al.  118  Pac.  354  (1911). 


44  PUBLIC  UTILITIES 

that  time  when  portions  of  the  plant  are  completed,  paid 
for  and  turned  over  to  the  operating  forces.  During 
this  period  there  will  be  a  loss  of  adequate  return  upon 
the  capital  brought  together  for  the  development  of  the 
undertaking. 

It  is  to  be  noted  that  for  the  usual  case  as  above  de- 
scribed, the  period  is  not  taken  as  the  entire  construction 
period  but  the  time  up  to  that  when  portions  of  the  plant 
can  be  turned  over  to  the  operating  forces.  For  each 
special  case,  therefore,  a  study  must  be  made  to  deter- 
mine when,  in  the  entire  development  period,  definite 
portions  of  the  plant  can  be  completed. 

When  a  large  property  is  created,  some  time  is  required 
to  complete  the  organization,  both  of  executive  and  of 
construction  forces,  to  make  engineering  plans  and  spec- 
ifications, and  to  order  and  obtain  the  material  required 
for  the  plant.  Money  must  be  expended  for  this  work 
before  actual  construction  is  undertaken.  It  has  become 
usual,  however,  in  making  valuations,  to  date  the  period 
of  construction  from  the  time  of  beginning  actual  work 
upon  the  physical  plant  and  to  care  for  the  loss  of  interest 
upon  expenditures  prior  to  that  time  as  portions  of  other 
overhead  charges,  such  as  "  organization/'  or  "  engineer- 
ing," and  to  figure  the  loss  of  interest  during  construc- 
tion only  on  the  material  and  labor  employed  in  actual 
construction  work. 

Again,  as  a  practical  matter,  the  cost  of  labor  and  of 
much  material  is  paid  for  as  the  work  progresses.  It 
is  now  usual  to  assume  that  work  of  building  a  plant  pro- 
gresses fairly  uniformly  during  the  construction  period, 
so  that  the  mean  time  during  which  the  interest  upon 
the  capital  expended  will  be  lost,  will  be  one-half  of  the 
construction  period. 

Relative  to  this  matter  the  Wisconsin  Commission  has 
said:  — 


DETERMINATION  OF  REPLACEMENT  COST  45 

"That  interest "  during  construction  .  .  .  "is  a  proper 
item  of  value,  is  indisputable.  Where  the  plant  construction 
is  financed  by  borrowing,  the  use  of  such  money  must  be  paid 
for  in  the  form  of  interest.  Where  the  corporation  finances 
itself  and  no  money  is  borrowed,  an  interest  charge  is  neverthe- 
less incurred,  for  the  money  thus  occupied  during  construc- 
tion is  entitled  to  current  interest  for  the  period  so  engaged. 
The  amount  to  be  allowed  for  the  purpose  of  valuation,  from 
a  theoretical  standpoint  at  least,  should  be  at  the  current  rate 
for  money  from  the  time  when  financing  must  be  arranged, 
directly  preceding  the  beginning  of  construction,  until  the  com- 
pletion of  the  plant.  It  is  not  difficult  to  conceive  of  condi- 
tions under  which  the  interest,  as  so  computed,  would  be  a 
very  large  item,  since  organization  and  franchise  expenses  and 
land  purchases  may  be  long  in  advance  of  actual  construction. 
Actual  practice,  however,  shows  that  this  course  of  financing 
is  not  generally  adhered  to.  Since  not  all  of  the  money  used 
for  construction  is  required  during  the  entire  period  in  ques- 
tion, it  follows  that  the  borrowing  is  more  in  the  nature  of  fre- 
quent short  time  loans,  taken  out  as  the  construction  progress 
requires.  If  all  the  money  is  borrowed  at  once,  proper  econ- 
omy would  require  the  re-investment  of  such  portion  as  is  not 
needed,  and  the  interest  thus  earned  operate  to  reduce  the  net 
charge  on  account  of  the  loan."  1 

The  principles  above  outlined  seem  to  have  been  fol- 
lowed in  most  large  appraisals  made  in  the  United  States. 
It  appea'rs  to  have  been  assumed  that  work  done  in  one 
year  can  be  completed  in  most  cases  during  that  year, 
that  financing  will  be  made  sufficient  only  to  defray  the 
cost  of  the  work  of  that  year  and  that  money  will  be 
obtained  at  the  legal  rate  of  interest,  6  per  cent.  These 
assumptions  have  led  to  an  extended  use  of  3  per  cent  as 
the  figure  to  be  assigned  as  the  loss  of  interest  during 
construction.  Such  a  figure,  based  on  the  above  assump- 
tions, may  be  a  rough  approximation  in  most  cases  to  a 
proper  percentage  to  be  used  for  this  overhead  charge. 
Its  adoption  would  certainly  tend  toward  the  uniform- 

1  Wis.  R.  R.  Com.  Rpts.,  Vol.  5,  p.  917. 


46  PUBLIC  UTILITIES 

ity  in  valuations  which  is  so  desirable.  But  it  must  be 
definitely  recognized  that  a  general  figure,  like  the  above, 
cannot  be  adopted  for  all  cases  without  the  certainty  of 
injustice,  due  to  the  inaccuracy  which  may  result  in  the 
valuation  of  the  properties  of  many  large  undertakings. 
Nor  would  such  inaccuracies  be  theoretical,  but  intensely 
practical.  The  question  of  interest  during  construction, 
which  is  admitted  by  all  authorities  as  a  proper  charge 
to  the  construction  cost  of  a  plant  both  when  originally 
built  or  theoretically  replaced,  is  of  fundamental  impor- 
tance as  it  is  connected  intimately  with  the  further  prob- 
lem, yet  to  be  solved,  as  to  how  the  quickening  factor, 
that  which  will  transform  the  value  of  a  "dead  plant" 
into  a  "live  one,"  is  to  be  found. 

39.  Overhead  charges  —  Interest  during  construction. 
Mean  weighted  time.  —  There  are  two  considerations 
involved  in  a  determination  of  the  "loss  of  interest  during 
construction" :  first,  what  will  be  the  mean  time,  weighted 
by  the  amounts  expended,  during  which  portions  of  the 
plant  will  be  under  construction  and  before  they  can  be 
turned  over  to  the  operating  forces  to  furnish  service  to  the 
public;  and  second,  at  what  rate  of  interest  should  it  be 
figured  that  this  idle  money  was  costing  the  undertaking. 

The  average  time  occupied  in  completing  portions  of 
the  plant  must  be  found  by  a  special  study  of  each  par- 
ticular case  in  detail.  If  the  case  is  the  replacement  of  a 
large  telephone  property,  land  will  have  to  be  purchased, 
buildings  and  switchboards  constructed,  and  outside 
plant  built,  before  a  single  subscriber  can  be  given  ser- 
vice, that  is  to  say,  before  those  plant  elements  can  be 
turned  over  to  the  operating  departments.  Clearly, 
therefore,  at  the  outset  and  for  portions  of  the  plant  con- 
structed later,  the  period  of  construction  will  be  more 
than  one  year.  The  mean  time  of  construction  can  be 
found  only  by  an  engineering  study  of  the  amounts  of 


DETERMINATION  OF  REPLACEMENT   COST  47 

money  to  be  expended  each  year  for  the  several  classes 
of  plant  and  of  the  dates  when  the  money  thus  expended 
can  be  considered  as  a  part  of  the  cost  of  the  operating 
plant.  Such  a  study  may  be  somewhat  laborious  but  it 
is  a  simple  and  usual  engineering  problem  and  one  which 
can  be  solved  without  the  probability  of  reasonable  con- 
tention. Knowing  the  amounts  expended  and  the  time 
such  sums  are  invested  in  an  idle  plant,  it  is  a  simple  mat- 
ter to  determine  the  weighted  mean  time  during  which 
there  is  a  loss  of  interest. 

40.  Overhead  charges  —  Interest  during  construction. 
Rate  of  interest.  —  The  question  of  the  proper  rate  of 
interest  to  be  charged  upon  such  idle  plant  during  con- 
struction is  more  difficult  of  determination,  as  there  are 
a  number  of  economic  problems  to  be  solved  if  an  attempt 
is  made  to  answer  this  question  by  a  detailed  analysis. 
It  will  be  found  best  to  follow  the  usual  custom  and  use 
the  rate  of  interest  which  the  undertaking  would  have 
to  pay  for  the  money  required  to  build  the  plant  on  the 
supposition  that  the  money  required  for  the  plant  was 
raised  by  the  sale  of  bonds.  Clearly  no  definite  rate  can 
be  established  which  will  cover  all  cases,  as  the  interest 
which  must  be  paid  will  depend  upon  the  location  of  the 
enterprise  and  the  hazard  or  risk  involved.  In  such 
rate  must  be  included, 

"the  legitimate  charges  of  marketing  the  securities,  not  includ- 
ing, however,  any  discount  on  those  securities,  except  so  much 
as  may  be  the  legitimate  commission  to  the  bankers  for  the 
expense  of  marketing."  1 

In  determining  what  interest  should  be  used  for  the 
replacement  cost,  the  assumption  must  be  made  that  a 
new  undertaking  is  about  to  construct  the  hypothetical 
replacing  plant. 

1  Massachusetts  Validation  Commission  Rpt.,  Feb.  15,  1911. 


48  PUBLIC  UTILITIES 

"The  rate  must  not  be  that  upon  which  an  existing  and  success- 
ful corporation  could  borrow,  as  the  credit  rather  than  the 
actual  hazard  would  be  reflected  in  this  rate;  neither  should 
the  rate  at  which  the  company  has  borrowed  money  be  con- 
trolling, though  it  may  be  confirmatory  evidence.  The  cus- 
tomary rate  of  interest  prevailing  upon  loans  of  equal  security 
or  hazard  should  govern."  1 

The  Wisconsin  Commission  has  used  quite  generally 
a  rate  of  6  per  cent  per  annum  for  cases  that  have  come 
within  its  jurisdiction. 

A  recent  decision  in  Minnesota  is: 

"Interest  on  the  cost  of  reproduction  of  railway  property 
at  4  per  cent  per  annum  during  one-half  the  time  requisite  to 
acquire  and  construct  it  is  a  necessary  expense  of  reproduction 
and  may  be  lawfully  allowed  as  such."  2 

It  may  be  contended  by  the  public  that  an  interest 
rate  determined  in  this  manner  is  too  high  for  the  reason 
that,  if  the  undertaking  had  its  funds  in  hand  at  the 
initiation  of  the  enterprise,  it  could  have  invested  such 
funds  in  such  a  way  that  they  could  be  drawing  interest, 
possibly  at  a  lower  rate,  and  at  the  same  time  be  avail- 
able to  pay  for  the  plant  as  the  work  progressed.  This 
could  be  done  if  the  funds  were  placed  in  the  bank  or,  if 
they  were  placed  as  short  time  loans,  an  even  higher  rate 
of  interest  might  be  received. 

On  the  other  hand  it  may  be  contended  by  the  under- 
taking that  such  a  rate  of  interest  as  six  per  cent  was 
too  low;  that  the  use  of  the  word  " interest"  in  this  con- 
nection was  misleading.  Interest  is  the  market  rate  for 
money  under  the  special  conditions  prevailing.  The 
undertaking  is  seeking  a  proper  and  ample  "  return," 
—  " interest"  plus  a  " profit."  The  investor  has  placed 
his  money  in  the  undertaking  with  the  expectation  of  a 

1  Paraphrase  —  "Water- Works  Valuations,  in  the  Light  of   Maine  Su- 
preme Court  Decisions,"  Leonard  Metcalf,  Trans.  Am.  Soc.  C.  E.,  Vol.  44. 
J  Shepard  v.  Northern  Pacific  R.  R.  Co.,  184  Fed.  765. 


DETERMINATION  OF  REPLACEMENT  COST     49 

return  greater  than  the  interest  which  might  be  obtained 
from  the  banks  or  from  call  loans.  This  difference  be- 
tween the  expected  return  and  the  interest  that  can  be 
obtained  at  current  rates  is  the  profit,  to  which  he  is  justly 
and  legally  entitled,  due  to  the  risk  incurred  in  the  opera- 
tion of  the  undertaking.  Clearly  the  rate  of  return  to 
which  he  is  entitled  is  lost  during  the  construction 
period.  This  loss  cannot  be  avoided,  and  is  as  much  a 
portion  of  the  cost  of  the  construction  of  the  plant  as  the 
material  and  labor  which  is  employed  in  building  the 
plant. 

While  there  is  ample  ground  upon  which  an  undertaking 
can  claim  its  right  to  a  return  over  and  above  usual  rates 
of  interest,  it  must  be  remembered  that  the  question  now 
at  issue  is  the  valuation  of  the  property  on  the  basis  of 
what  it  would  cost  to  construct  it  at  the  present  time  with- 
out regard  to  the  method  in  which  the  funds  were  obtained 
originally  or  to  the  return  which  is  to  be  expected  from 
the  operation  of  the  plant  after  it  has  been  constructed. 
The  question  now  at  issue  is  simply  to  find  the  replace- 
ment cost  of  the  physical  plant  and  to  include  in  such 
costs  only  such  items  as  will  be  found  again  when  the  ele- 
ments become  worn  out  and  have  to  be  renewed.  The 
adoption  of  the  current  rate  of  interest  removes  all  doubts 
or  contentions. 

41.  Overhead  charges  —  Engineering.  —  Another  ex- 
pense of  a  general  nature  in  the  construction  of  the  plant 
of  an  undertaking  is  that  of  the  engineer  and  of  his  assist- 
ants. This  expense  has  been  recognized  in  all  appraisals 
and  has  been  figured,  in  every  case,  as  an  overhead 
charge. 

Most  of  the  work  of  the  engineering  force  is  of  per- 
manent value  to  the  undertaking  and  is  essential  to  the 
greatest  economy  and  efficiency  in  the  construction  and 
operation  of  the  plant.  Among  the  expenses  attributable 


50  PUBLIC  UTILITIES 

to  engineering  must  be  included  the  cost  of  the  preliminary 
engineering  necessary  to  present  to  the  public  at  the  ini- 
tiation of  the  enterprise  the  possibility  of  its  success,  that 
a  plant  can  be  constructed,  what  its  probable  cost  would 
be,  as  well  as  what  returns  from  the  investment  might 
be  expected  in  successive  years  after  its  completion. 
Capital  cannot  be  interested  in  an  undertaking  until 
such  knowledge  has  been  obtained,  nor  can  the  final  and 
detailed  plans  upon  which  the  actual  construction  work 
is  to  proceed  be  formed  until  preliminary  and,  in  many 
cases,  comprehensive  plans  have  been  made  to  determine 
upon  what  lines  the  most  economical  development  of  the 
plant  can  be  made. 

Where  such  comprehensive  preliminary  or  fundamental 
plans  have  been  made,  they  are  a  legitimate  portion  of 
the  cost  of  the  development  of  the  undertaking  and, 
in  consequence,  should  be  included  as  a  portion  of  the 
replacement  cost. 

In  addition  to  this  there  is  the  expense  of  the  engineer 
and  his  staff  in  making  fundamental  plans  which  are  of 
such  a  character  as  will  permit  of  the  construction  of  the 
plant  as  a  whole  upon  well  considered  lines  of  development 
so  that  the  least  money  will  be  expended  consistent  with 
service  most  satisfactory  to  the  public.  The  engineer 
also  makes  plans  and  specifications  showing  the  types  of 
construction  to  be  used  for  each  plant  element  as  well  as 
the  materials  that  are  to  be  purchased  and  used.  He 
also  makes  special  detailed  plans  for  any  large  new  addi- 
tion to  the  plant.  All  of  this  work  is  of  a  permanent  char- 
acter and  becomes  part  of  the  property  of  the  company 
which  is  of  distinct  value.  Such  plans  and  specifications 
may  become  old,  out  of  date  and  possibly  nominally 
obsolete,  but  actually  they  are  never  obsolete  as  they 
are  fundamental  in  their  character  and  upon  them  are 
based  the  changes  which  time  may  show  as  desirable. 


DETERMINATION  OF  REPLACEMENT  COST     51 

42.  Overhead     charges  —  Organization     expense.  — 

This  item  is  a  legitimate  and  natural  overhead  charge. 
It  should  be  designed  to  cover  all  expenses  to  which  the 
officers  of  the  organization  would  be  put  in  bringing 
together  the  men  and  material  necessary  for  the  creation 
of  the  undertaking  and  its  property,  as  well  as  to  cover 
the  cost  of  the  oversight,  necessary  on  the  part  of  the 
higher  officials  of  the  undertaking,  of  the  actual  construc- 
tion of  the  plant. 

It  is  to  be  remembered  that  in  defining  unit  costs,  the 
cost  of  labor  was  made  to  include  the  time  and  expenses 
of  those  actually  engaged  upon  the  work,  thus  carrying 
the  charges  up  to  and  including  the  sub-foreman  of  the 
gang  doing  a  specific  piece  of  work.  This  method  of 
figuring  unit  costs  was  adopted  for  the  reason  that,  as 
these  men  are  engaged  upon  one  piece  of  work  at  a  time, 
it  is  a  perfectly  simple  matter  to  determine  the  costs  of 
their  work  with  accuracy.  But  officials  of  the  company 
ranking  above  the  sub-foreman  are  obliged  to  spend  a 
certain  portion  of  their  time  not  only  in  supervising  the 
actual  work  done  in  construction  but,  preliminary  to  the 
construction  work,  in  planning  the  character  of  the  plant 
to  be  built  and  the  position  which  it  must  occupy.  More- 
over, time  must  be  spent  in  bringing  together  the  con- 
struction force,  in  a  general  supervision  of  the  plans  of 
the  engineer,  of  the  purchase  of  material,  land  and  build- 
ings and  other  administrative  work  always  incident  to 
the  construction  of  a  large  plant.  All  of  this  work,  to- 
gether with  the  office  expenses  incurred  in  carrying  it  out, 
must  be  included  in  this  overhead  charge. 

In  addition  to  this  cost  of  general  supervision,  an  under- 
taking must  incur,  at  its  initiation,  expense  in  bringing 
together  its  working  forces,  interesting  capital  and  obtain- 
ing loans,  charters  and  franchises.  It  is  not  intended  to 
include  under  this  item  other  amounts  than  those  paid 


52  PUBLIC  UTILITIES 

as  salaries  and  office  expenses  to  those  actually  in  the 
employ  of  the  undertaking.  Costs  of  franchise  and  other 
similar  expenses  will  be  considered  later.  A  determina- 
tion of  costs  properly  to  be  included  in  this  item  must 
rest  upon  the  experience  and  judgment  of  those  making 
the  appraisal.  It  must  be  determined  by  a  consideration 
of  the  conditions  presented  by  the  special  case  under 
investigation. 

43.  Overhead  charges  —  Legal  expense. —  In  most 
large  appraisals,  legal  expenses  have  been  cared  for  as  a 
special  overhead  charge.  In  such  expenses  should  be 
included  the  cost  of  the  legal  advice  necessary  at  the  time 
of  the  formation  of  the  enterprise,  and  other  legal  expenses, 
such  as  inevitably  arise  in  obtaining  the  charter  of  the 
undertaking,  the  franchise  under  which  it  is  to  operate, 
in  drafting  the  by-laws,  and  in  approving  the  forms  to 
be  used  in  the  operation  of  the  undertaking. 

Unquestionably  no  property,  of  the  size  and  nature  of 
that'  under  consideration,  could  be  brought  together, 
plant  constructed  and  the  company  placed  in  an  operat- 
ing condition,  without  incurring  considerable  expense  of 
this  character.  It  is  a  question,  however,  whether  this 
overhead  charge  could  not  be  omitted  and  the  legal 
expenses  of  the  undertaking  included  as  a  portion  of  the 
cost  of  the  organization.  This  question  is  purely  academic 
and  of  no  special  importance.  The  expenses  for  legal 
services  are  necessarily  incident  to  the  replacement  of  the 
property  of  the  undertaking  and,  in  consequence,  must  be 
included  properly  in  figures  derived  to  show  replacement 
cost.  It  is  simply  a  matter  of  form  whether  these  expenses 
are  made  a  special  overhead  charge  or  are  included  with 
the  costs  of  organization. 

44.  Overhead  charges  —  Contingencies.  —  A  fifth 
overhead  charge,  known  as  "  contingencies,"  has  been 
used  in  most  large  appraisals.  This  item  is  intended  to 


DETERMINATION  OF  REPLACEMENT  COST  53 

cover  expenses  usually  encountered  in  the  construction 
of  a  large  property,  which  cannot  be  recognized  in  an 
appraisal.  In  many  valuations  this  item  seems  to  have 
been  made  omnibus  in  character  to  include  not  only 
unusual  costs  in  the  construction  of  the  plant  but  omis- 
sions of  the  appraiser  in  his  work  in  making  the  inventory. 

The  proper  weight  to  be  given  to  this  item  will  depend 
very  greatly  upon  how  much  care  has  been  exercised  in 
making  the  inventory  and  upon  how  far  the  items  above 
considered  as  a  portion  of  unit  costs  have  been  included 
actually  as  a  portion  of  such  costs.  Thus,  losses  on  tools 
and  materials  as  well  as  casualty  insurance  may  have 
been  considered  by  many  appraisers  as  a  portion  of  the 
charge  for  contingencies  and,  in  consequence,  the  per- 
centage to  be  added  for  contingencies  would  have  to  be 
higher,  naturally,  than  if  such  items  had  been  carefully 
determined  and  made  a  portion  of  the  unit  costs,  as  un- 
questionably they  should  have  been. 

Many  large  appraisals  have  been  made  in  a  very  lim- 
ited time  and,  in  consequence,  without  the  possibility  of 
such  careful  work  either  in  the  field  or  in  the  determina- 
tion of  unit  costs  in  the  office  as  is  to  be  desired.  In 
such  cases  this  item  may  be  accepted  as  one  of  fairly  large 
proportions.  On  the  other  hand,  a  valuation,  to  justify 
the  large  cost  which  is  entailed  in  its  preparation,  should 
be  made  with  such  care  that  no  question  can  be  raised  as 
to  its  accuracy,  and  the  inventory  and  unit  costs  should 
be  of  such  a  character  that  the  allowance  of  a  large  per- 
centage to  cover  omissions,  under  the  head  of  "  contin- 
gencies," should  not  be  required. 

This  overhead  charge  is  not  of  the  same  character  as 
the  others  already  described  but  is  one  that  has  been 
established  definitely  by  precedent. 

45.  Overhead  charges.  Other  possible  costs.  —  In 
what  has  been  said  in  the  preceding  sections,  there  have 


54  PUBLIC  UTILITIES 

been  established  four  classes  of  general  expense  incident 
to  the  construction  of  most  public  utility  properties, 
interest  during  construction,  engineering,  organization 
and  legal.  A  fifth  charge  of  this  character  has  been  dis- 
cussed, contingencies,  which  has  been  almost  universally 
regarded  as  a  necessary  item  to  be  included  in  the  fig- 
ures to  be  presented  by  the  appraisers  to  show  the  cost  of 
reproduction  of  a  property.  There  are  numerous  other 
possible  items  which  experts  and  appraisers  have  claimed 
should  be  figured  as  a  portion  of  the  cost  of  reproduction. 
A  few  of  the  more  important  of  these  items  will  be  dis- 
cussed as  briefly  as  possible. 

In  deciding  what  items  of  cost  can  be  included  properly 
in  an  appraisal,  it  is  necessary  to  keep  definitely  in  mind 
the  fact  that  a  determination  of  the  replacement  cost, 
through  the  medium  of  a  valuation,  has  not  for  its  object 
a  determination  of  what  it  had  cost  the  undertaking  to 
construct  its  property,  —  that  figure  is  the  original  cost, 
possibly  an  entirely  different  figure,  —  but  rather,  what  it 
would  cost  to  reproduce  the  property,  plant  and  busi- 
ness at  the  time  of  the  appraisal.  Most  of  the  addi- 
tional items,  for  which  recognition  is  demanded,  may  be 
properly  a  portion  of  the  original  cost  but  should  not  be 
considered  as  forming  a  part  of  the  reproduction  cost. 

46.  Promotion  costs.  —  This  item  of  cost  must  be  dis- 
tinguished from  "cost  of  organization,"  which  item  was 
considered  in  §  42.  Organization  cost  includes  the  sal- 
aries and  legitimate  expenses  of  those  initiating  a  new 
undertaking.  The  salaries  paid  to  these  officials  should 
be  sufficient  to  reward  them  for  their  originality  and 
skill  in  developing  and  forming  a  new  enterprise.  Organ- 
ization cost  has  been  allowed  and  should  be  given  as  lib- 
eral an  estimate  as  the  conditions  of  each  particular  case 
seem  to  justify. 

Promotion  cost,  as  used  here,  has  a  somewhat  different 


DETERMINATION  OF  REPLACEMENT  COST  55 

significance.  It  is  the  reward  to  the  promoter,  the  man 
who  initiated  the  undertaking  with  the  expectation  of  a 
return  greater  than  that  which  would  be  paid  him  in  the 
form  of  a  salary,  or  than  the  usual  return  upon  money 
invested  in  better  established  or  less  hazardous  enter- 
prises. 

It  must  be  definitely  recognized  that  the  cost  of  pro- 
motion is  a  very  practical  matter  and  that,  without  the 
expectation  of  such  reward  and  the  right  to  receive  it 
in  case  of  the  success  of  the  enterprise,  it  would  be  impos- 
sible to  obtain  the  required  funds  or  men  of  sufficient 
ability  or  skill  to  undertake  such  work.  But  the  present 
question  is  whether  such  reward  can  be  made  properly  a 
portion  of  the  replacement  cost  of  the  plant. 

Looking  at  this  question  from  the  practical  side,  it  is 
customary  in  a  large  majority  of  the  cases  of  the  initia- 
tion of  new  enterprises  to  give  to  the  promoters  and  to 
those  providing  the  funds  shares  of  common  stock  as  a 
bonus  or  reward.  In  such  cases,  the  common  stock  rep- 
resents no  money  actually  invested  in  the  plant  but 
enables  the  holders  of  such  stock  to  participate  in  any 
surplus  earnings  over  and  above  fixed  charges  and  a 
reasonable  return  upon  the  preferred  stock.  The  propri- 
ety of  this  method  of  financing  need  not  be  discussed. 
The  method  is  a  usual  one  and  indicates  the  fact  that 
there  is  nothing  in  the  transaction  affecting  the  replace- 
ment cost  of  the  property,  except  in  so  far  as  the  receipt  of 
the  common  shares  may  decrease  the  losses  which  might 
obtain  in  the  sale  of  securities,  as  those  buying  bonds  or 
stock,  with  which  a  block  of  common  stock  is  associated, 
might  be  willing  to  pay  a  higher  price  than  for  a  bond 
without  the  speculative  features  presented  by  the  com- 
mon stock. 

It  would  seem,  therefore,  that,  as  no  money  is  usually 
directly  paid  for  the  promotion  of  the  undertaking,  there 


56  PUBLIC  UTILITIES 

was  no  reason  whatever  for  including  this  factor  as  an 
element  tending  to  enhance  the  replacement  cost  of  the 
property. 

The  above  line  of  reasoning  may  appear  to  be  contrary 
to  some  of  the  decisions  of  state  commissions  on  this 
subject.  But  a  careful  reading  of  all  the  cases  where 
this  subject  is  discussed  seems  to  show  that  what  these 
decisions  call  " promoter's  profit"  or  "cost  of  promotion" 
is  more  nearly  covered  by  the  overhead  charge  of  cost  of 
organization. 

47.  Sale  of  securities.  —  This  item  is  intended  to  in- 
clude the  discounts  or  losses  which  an  undertaking  might 
incur  in  order  to  sell  its  stocks  or  bonds,  together  with 
such  expenses  as  may  be  incurred  by  underwriting  an 
issue  of  the  securities  of  an  undertaking  to  insure  the 
disposition  of  its  securities. 

In  considering  this  item  it  is  again  necessary  to  call 
attention  to  the  fact  that  it  is  the  replacement  cost  of 
the  plant  as  of  the  present  time  that  is  to  be  determined. 
It  is  not  what  the  capitalization  of  an  enterprise  should 
have  been  to  have  constructed  the  plant  but  what  amount 
of  money  would  have  to  be  spent  at  the  time  of  the 
appraisal  to  rebuild  it. 

It  is  probable  that  money  could  not  be  raised  sufficient 
to  construct  the  supposititious  new  plant  except  by  an 
offer  of  securities  below  par.  But  such  a  discount  is 
equivalent  to  a  higher  rate  of  interest,  and  this  interest 
enters  into  the  replacement  cost  only  during  the  con- 
struction period.  As  has  been  already  stated  the  rate 
upon  which  interest  during  construction  must  be  based 
is  that  which  would  have  to  be  paid  for  money  for  the 
replacing  plant,  such  a  rate  including  any  losses  which 
occur  in  the  sale  of  securities. 

It  will  be  seen,  therefore,  that  losses  in  the  sale  of  secu- 
rities are  already  fully  cared  for  under  the  head  of  interest 


DETERMINATION  OF  REPLACEMENT  COST  57 

during  construction  and  that  to  include  such  an  item 
as  a  specific  portion  of  the  replacement  cost  would  be  a 
duplication. 

48.  Contractor's  profit.  —  Discussion  as  to  the  treat- 
ment of  contractor's  profits  has  appeared  in  two  forms; 
first,  as  to  whether  the  overhead  charges  considered  above 
would  hold  in  case  a  portion  or  the  whole  of  a  plant  had 
been  built  by  a  contractor  rather  than  by  the  undertak- 
ing; and  the  second,  as  to  whether,  if  the  plant  had  been 
built  by  the  undertaking  it  would  not  be  entitled  to  the 
profit,  so  called,  which  is  usually  paid  to  a  contractor  for 
his  work. 

The  answers  to  both  of  these  questions  is  apparent. 
The  answer  to  the  first  is  that  the  unit  costs  and  over- 
head charges,  above  derived,  are  representative  of  what  it 
would  cost  an  undertaking  to  acquire  a  property  identical 
with  that  already  in  existence.  Whether  the  existing 
plant  was  constructed  by  a  contractor  or  not  is  imma- 
terial. And  second,  replacement  cost  is  the  sum  of  money 
which  would  have  to  be  expended  to  replace  the  existing 
plant  and  is  based  upon  fair  present  costs  of  labor  and 
material.  The  contractor's  profit,  so  called,  is  really  not 
a  profit,  if  the  fair  market  prices  of  labor  and  material 
are  used,  but  a  sum  sufficient  to  reimburse  the  contractor 
for  his  own  time  and  skill  and  for  the  expenses  which  he 
has  incurred  in  building  up  an  organization  capable  of 
carrying  out  the  work,  in  acquiring  the  tools  needed  in 
the  work,  in  caring  for  the  contingencies  inherent  in  the 
work  and  obtaining  the  credit  or  means  required  to  meet 
the  expenses  incurred  between  payments  for  his  work. 
All  of  these  items  are  properly  and  fairly  cared  for  in  the 
unit  costs  obtained  as  above  described  and  by  the  over- 
head charges. 

49.  Overhead  charges.    Method  of  application.  —  It 
will  be  assumed,  in  the  discussion  contained  in  this  sec- 


58  PUBLIC  UTILITIES 

tion,  that  definite  percentages  have  been  obtained  to 
cover  with  accuracy  the  five  items  of  cost  which  have 
been  described  above  as  properly  represented  by  over- 
head charges.  It  is  important  that  these  percentages 
should  be  applied  to  the  costs  of  the  several  plant  ele- 
ments as  obtained  by  multiplying  the  number  of  units 
of  each  element  found  in  the  plant  by  the  unit  costs, 
in  such  a  way  as  to  obtain  properly  the  replacement  cost. 

Before  studying  this  question  in  detail,  a  general  con- 
sideration is  necessary  as  to  whether  one  or  all  of  these 
overhead  charges  should  be  presented  as  independent 
items  in  the  valuation,  or  should  be  added  directly  to  the 
cost  of  the  elements  as  derived  by  the  use  of  unit  costs  so 
as  to  make  one  cost  for  each  of  the  elements.  Thus, 
if  the  replacement  cost  of  an  element  is  found  to  be 
$100,000.00,  using  unit  costs  alone,  and  one  of  the  over- 
head charges,  let  us  say  engineering,  is  found  to  be  ten 
per  cent  of  such  cost,  the  question  is  whether  the  replace- 
ment cost  of  the  element  shall  be  presented  as  $110,000.00 
or  as  $100,000.00.  In  the  latter  case  it  would  be  neces- 
sary to  make  engineering  a  special  item  of  the  inventory 
and,  as  far  as  this  item  alone  is  concerned  in  such  a 
case  as  is  cited,  given  a  value  of  $10,000. 

The  necessity  for  this  consideration  is  twofold;  first, 
as  affecting  the  question  of  depreciation;  and  second,  as 
to  whether  the  application  of  the  percentages  for  over- 
head charges  shall  be  compounded. 

Relative  to  the  first  of  these  considerations,  it  must  be 
appreciated  that,  after  the  replacement  cost  has  been 
found,  it  will  be  necessary  to  find  another  figure  to  show 
by  how  much  the  value  of  each  element  has  been  reduced 
by  the  time  that  each  element  has  been,  on  the  average, 
in  service.  This  depreciation  value  is  obtained  from 
figures  based  upon  the  replacement  cost  of  the  element 
and  upon  the  relation  of  the  years  of  service  to  the  years 


DETERMINATION  OF  REPLACEMENT  COST     59 

of  probable  usefulness  of  the  element.  If  the  amounts 
represented  by  the  overhead  charges  are  made  a  portion 
of  the  replacement  cost  of  the  element,  then  the  expenses, 
which  they  represent,  are  made  to  depreciate  with  the 
element.  If  they  are  made  separate  items,  then  they  can 
be  cared  for  in  any  manner  that  seems  proper,  independ- 
ently of  the  elements  to  which  they  may  be  applied. 

This  question  might  be  made  the  subject  of  an  extended 
discussion,  particularly  with  regard  to  one  or  more  of  the 
overhead  charges.  No  attempt  will  be  made  to  present 
the  various  arguments  which  may  be  made  as  to  what 
method  should  be  employed.1  It  will  be  stated,  more  or 
less  arbitrarily,  that  each  overhead  charge  should  be  pre- 
sented as  an  individual  item  exactly  as  if  it  were  in  itself 
an  independent  element  of  the  plant.  Thus,  organiza- 
tion, engineering,  and  iegal  expenses,  although  obtained 
by  an  application  of  percentages  to  the  costs  of  certain 
elements,  will  not  be  made  a  portion  of  the  cost  of  those 
elements,  but  the  sum  of  the  amounts,  derived  by  the 
application  of  these  percentages  to  the  several  elements 
affected,  will  be  presented  as  a  definite  sum  for  engineer- 
ing, another  for  organization,  and  others  for  the  other 
overhead  charges.  Clearly,  such  a  method  of  valua- 
tion will  not  affect,  in  any  way,  the  total  replacement 
cost,  but  it  will  affect  the  replacement  cost,  as  presented, 
of  the  individual  elements. 

This  method  is  unquestionably  proper  for  the  reason 
that,  although  the  expenses  incurred  under  the  heads  of 
engineering,  and  organization,  may  include  a  certain 
amount  of  supervision  which  will  have  to  be  reincurred 
when  the  plant  is  replaced,  still  the  cost  of  the  super- 
vision that  will  have  to  be  reincurred  is  relatively  so 
small  as  to  be  entirely  negligible.  It  is  difficult  to  see 
how  legal  expense  will  be  reincurred  when  units  become 

1  See  In  re  Met.  St.  Ry.  Co.  —  N.  Y.  P.  S.  C.,  1st  Dist.,  Vol.  Ill,  p.  155. 


60  PUBLIC  UTILITIES 

worn  out  and  have  to  be  replaced.  The  item  of  contin- 
gencies is  of  such  a  doubtful  character  that  it  had  best 
be  segregated,  if  it  is  used  at  all.  At  first  sight  it  would 
seem  that  interest  during  construction  was  an  item  of 
expense  that  would  have  to  be  reincurred  and,  in  conse- 
quence, that  it  should  be  made  a  part  of  the  cost  of  each 
element  and,  consequently,  depreciated  with  it.  But  a 
consideration  of  the  practical  conditions  existing  at  the 
time  of  renewal  shows  that  but  an  extremely  small  por- 
tion, so  small  as  to  be  practically  negligible,  of  the  orig- 
inal charge  for  interest  during  construction  will  have  to 
be  reincurred.  Interest  during  construction  is  the  loss 
of  return  on  money  tied  up  in  plant  under  construction 
and,  in  consequence,  not  earning.  In  most  cases,  at  the 
time  of  replacement,  the  plant  is  earning,  and  even  the 
material  required  to  replace  that  no  longer  serviceable 
forms  a  part  of  the  working  capital  and,  consequently,  can 
be  figured  as  a  portion  of  the  assets  upon  which  a  return 
can  be  obtained. 

From  general  considerations  and  for  the  reasons  above 
briefly  stated,  it  would  seem  best  to  include  the  amounts 
derived  through  overhead  charges  as  individual  elements 
of  plant  costs. 

Relative  to  the  second  consideration  as  to  whether 
overhead  charges  should  be  applied  in  such  a  way  as  to 
be  compounded,  it  must  be  admitted  that  there  has  been 
such  a  wide  variation  in  the  methods  employed  in  large 
valuations  made  in  the  past  as  to  have  established  no 
definite  precedent. 

Theoretically,  engineering  should  be  made  an  inde- 
pendent item  and  included  with  the  others  to  which  the 
percentage  representative  of  loss  of  interest  during  con- 
struction should  be  applied.  This  seems  logical  when 
it  is  remembered  that  most,  if  not  all,  engineering  expense 
is  incurred  prior  to  the  completion  of  the  construction 


DETERMINATION  OF  REPLACEMENT  COST  61 

work  and,  in  consequence,  the  interest  on  the  money 
required  for  such  engineering  is  lost  during  the  construc- 
tion period.     This  practice  has  been  followed  in  many  of— 
the  largest  appraisals. 

It  is  difficult  to  see  why  interest  during  construction 
should  not  be  applied  to  organization  and  legal  expenses, 
following  the  same  line  of  reasoning,  but  there  is  sub- 
stantially no  precedent  for  such  a  practice. 

50.  Real  estate.  —  The  valuation  of  land  is  one  of 
the  most  difficult  elements  of  an  appraisal,  due  to  the 
fact  that  the  value  of  such  property  is  looked  at  ordina- 
rily from  many  points  of  view.  A  real  estate  investor  or 
speculator  may  give  land  one  value,  whereas  bank  officers 
or  others  lending  money  upon  real  estate  are  naturally 
inclined  to  place  the  value  of  the  property  at  a  consider- 
ably lower  figure.  What  is  required  for  the  replacement 
cost  is  the  fair  market  value  of  the  land  at  the  time  of  the 
appraisal,  or  in  other  words  such  a  sum  of  money  as  would 
be  paid  by  a  willing  buyer  to  a  willing  seller. 

Fair  values  for  real  estate  can  be  given  by  the  engi- 
neers making  the  appraisal  of  the  physical  property  of 
undertakings  in  but  few  cases.  The  engineers  must 
depend  largely  upon  the  personal  opinions  of  men  familiar 
with  the  prices  paid  for  similar  property  in  that  local- 
ity, upon  whose  judgment  as  to  local  values  reliance 
can  be  placed.  The  appraiser  must  establish  what,  in 
his  opinion,  the  proper  value  should  be,  after  properly 
weighing  all  the  evidence  and  figures  obtained  from  local 
real  estate  experts.  In  presenting  the  final  figure  as  to 
the  value  of  the  property,  the  engineer  will  find  it  best,  in 
most  cases,  to  present  the  figures  obtained  from  the  real 
estate  experts,  giving  his  own  reasons  for  adopting  the 
final  figure.  Frequently  it  will  be  of  advantage, — simply 
as  corroborative  evidence,  —  to  obtain  the  prices  paid  in 
recent  sales  for  surrounding  or  similarly  situated  land  and 


62  PUBLIC  UTILITIES 

determine  the  ratio  which  such  sales  bear  to  the  assessed 
valuation.  Such  a  ratio  applied  to  the  assessed  value  of 
the  land  in  question  would  throw  some  light  upon  the 
correctness  of  the  value  obtained  for  the  appraisal. 

The  value  of  land  determined  by  comparison  with 
current  sales  of  similarly  situated  real  estate  and  by  the 
best  expert  opinion  will  give  as  good  figures  as  probably 
can  be  obtained  for  most  cases  where  the  uses  to  which  the 
land  is  put  may  not  result  in  a  change  in  its  value.  Thus 
land  used  by  telephone  companies  is  developed  usually 
by  the  construction  of  buildings  conforming  in  outward 
appearance  to  the  character  of  those  in  the  vicinity, 
nor  are  there  any  special  features  introduced  by  its  use 
to  influence  the  value  of  surrounding  property  more  than 
would  be  caused  by  the  construction  of  a  similar  high 
grade  building  for  business  or  residential  purposes. 

For  the  land  used  by  railroads  as  a  right-of-way  or  for 
terminals,  the  conditions  are  very  different.  The  right- 
of-way,  being  a  relatively  narrow  and  continuous  strip 
of  land,  frequently  cuts  up  the  property  of  an  owner 
so  as  to  seriously  damage  that  which  is  not  sold :  it  makes 
access  in  some  cases  from  one  part  of  the  remaining  prop- 
erty to  the  other  more  difficult,  and  in  most  cases  it  is 
claimed  that  the  railroad  itself  tends  to  damage  the  prop- 
erty contiguous  to  the  railroad.  Whether  or  not  all  of 
these  reasons  should  hold  as  good  against  the  general 
enhancement  in  the  value  of  land  due  to  the  increased 
ease  of  communication  incident  to  the  operation  of  the 
railroad  and  the  encouragement  thereby  afforded  to 
the  construction  of  manufacturing  establishments  or  for 
the  disposal  in  more  distant  markets  of  the  products  of 
the  farms,  the  fact  remains  that  the  railroads  have  had 
to  pay  more  for  the  land  which  they  occupy  than  is 
usually  paid  for  land  similarly  situated  and  used  for 
farming,  residence,  or  business  purposes. 


DETERMINATION  OF  REPLACEMENT  COST     63 

In  view  of  these  facts,  it  has  been  the  custom,  in  the 
appraisal  of  railway  property  to  determine  with  the 
greatest  care  based  upon  as  many  individual  cases" 
as  possible  for  land  in  thickly  settled,  sparsely  settled 
and  in  farming  or  wild  country,  the  ratio  of  the  prices 
paid  by  railroads  for  their  land  to  the  fair  present  usual 
prices  as  given  by  real  estate  experts  after  the  manner 
of  valuation  described  above.  Their  figures,  based  on 
current  prices  for  ordinary  sales,  have  been  raised  by  the 
ratios  properly  applicable  to  the  land  under  appraisal. 

In  many  cases,  particularly  in  appraisals  of  the  lands 
forming  the  right-of-way  and  terminals  of  railroads, 
it  may  be  found  best  to  eliminate  expert  opinion  and 
derive  the  present  value  entirely  from  the  records  of  the 
prices  paid  by  railroads  for  land  as  compared  with  those 
paid  by  others  for  contiguous  or  similarly  situated 
property. 

The  difficulty  in  obtaining  satisfactory  expert  opinion  is 
that  such  personal  judgment  is  influenced  almost  in  vari- 
ably by  the  present  uses  of  the  property.  Theoretically, 
the  value  that  is  desired  is  what  the  fundamental  fair 
market  value  is  without  any  regard  whatever  as  to 
the  purposes  for  which  the  land  is  to  be  used.  If 
the  value  of  land  is  increased  by  the  ratio  of  such 
price  to  the  mean  advanced  price  which  railroads 
usually  have  to  pay  for  their  land,  and  if  this  value  is 
advanced  still  further  as  a  portion  of  the  entire  property 
of  the  company,  when  recognition  is  made  of  the  value 
inherent  in  the  property  as  a  whole  as  a  "live"  operat- 
ing entity,  and,  still  further,  by  the  percentages  repre- 
sentative of  overhead  charges,  —  such  as  engineering,  legal 
and  contingencies,  —  it  is  apparent  that  the  value  of  land 
will  become  abnormally  inflated.  Manifestly  it  is  unfair  to 
base  the  fundamental  value  of  the  land  upon  the  estimates 
of  men  who  cannot  but  be  influenced  by  its  use  for  a  par- 


64  PUBLIC  UTILITIES 

ticular  purpose.  Such  a  method  would  be  somewhat 
analogous  to  enhancing  the  replacement  cost  by  the 
presence  of  the  plant  being  replaced,  which,  as  has  just 
been  shown,  is  inequitable. 

A  somewhat  similar  question  enters  in  the  valuation  of 
the  land  occupied  by  a  telephone  central  office  building. 
Such  a  building  must  be  at  the  centre  of  distribution  of 
all  lines  radiating  from  the  central  office.  In  the  cases 
of  large  offices,  the  difference  in  the  first  cost  of  plant  at 
the  centre  and  one  fifty  or  one  hundred  feet  away  would 
amount  to  many  thousands  of  dollars.  A  telephone 
company  in  acquiring  the  land  originally  would  be  justified 
in  paying  more  for  land  at  the  centre  of  distribution  of 
its  system  of  wires  than  the  usual  or  current  market 
value  of  similar  property,  and  in  many  cases  it  may  have 
paid  such  enhanced  price.  But  in  making  the  appraisal, 
such  special  value  due  to  strategic  position  cannot  be 
made  a  portion  of  the  replacement  cost.  The  advantages 
or  disadvantages  of  location  are  properly  cared  for  by 
considerations  of  the  value  inherent  in  the  live  property. 

In  addition  to  the  value  of  the  land,  the  expenses 
usually  incurred  in  buying  the  land,  in  abstracting  titles, 
recording  the  deeds  and  other  similar  expenses  should 
be  added. 

61.  Cost  of  land  affected  by  cost  of  hypothetical  build- 
ings. —  Further,  it  is  usually  difficult,  if  not  impossible, 
to  acquire  land  properly  situated,  upon  which  there  is 
not  already  a  building  of  a  kind  unsuited  to  the  purposes 
of  the  undertaking.  The  undertaking,  when  it  acquired 
the  land  originally,  had  to  purchase  the  buildings  found 
upon  it  and  to  incur  some  expense  in  their  removal.  Thus 
the  original  cost  of  the  land  included  not  only  the  land 
itself  but  the  buildings  found  upon  it  and  with  such  cost 
should  have  been  included  the  amount  paid  for  their 
removal.  In  determining  the  replacement  cost,  it  is  not 


DETERMINATION  OF  REPLACEMENT  COST  65 

proper  to  assume  that  the  figures,  obtained  from  experts 
to  show  the  market  value  of  the  naked  land  at  the  pres- 
ent time,  show  the  entire  present  value  of  the  land.  Nor 
would  it  be  proper  to  add  to  such  value  what  had  been 
paid  originally  for  the  buildings  found  upon  the  land  and 
for  removing  the  buildings.  The  entire  character  of  the 
buildings  in  that  locality  may  have  changed  between 
the  time  of  the  original  purchase  and  the  time  of  the 
appraisal.  The  replacement  cost  being  what  it  would 
cost  at  the  present  time  to  build  a  similar  plant  must  be 
based,  in  this  instance,  upon  what  it  would  cost  for  the 
land  encumbered  by  such  a  building  as  would  in  all  prob- 
ability have  been  found  upon  the  land  at  the  present  time, 
if  it  had  not  been  utilized  by  the  undertaking.  The 
determination  of  such  a  figure  is  not  a  difficult  matter 
in  most  cases.  It  must  not  be  based  necessarily  upon 
what  it  would  cost  to  purchase  and  remove  the  existing 
structure  nor  must  it  be  based  upon  the  cost  of  such  a 
structure  as  would  be  likely  to  be  built  upon  land  similarly 
situated  at  the  present  time.  The  best  method  to  pur- 
sue is  to  determine  the  mean  cost  of  buildings  in  that 
locality,  that  is  to  say,  within  the  same  or  adjacent  blocks, 
and  use  this  mean  figure,  plus  the  probable  cost  of  their 
removal,  as  the  sum  which  must  be  added  to  the  cost  of 
the  land  as  previously  determined,  in  order  to  show 
what  it  would  cost  at  the  present  time  to  acquire  the  land 
needed  for  a  utility  of  the  character  of  that  under 
appraisal,  i.e.,  the  replacement  cost  of  the  land. 

It  should  be  noted  that  the  above  method  cannot  be 
rigidly  followed  in  all  valuations,  but  must  be  modified 
to  meet  the  special  conditions  presented  by  each  special 
case.  The  method  above  outlined  could  be  followed 
safely  in  the  case  of  most  telephone  buildings,  as  the  econ- 
omies produced  in  the  operation  of  a  large  telephone 
system  demand  that  the  central  office  building  shall  be 


66  PUBLIC  UTILITIES 

situated  at  a  point  as  nearly  at  the  centre  of  distribution 
of  its  system  of  wires  as  possible.  Moreover,  the  sav- 
ing to  the  telephone  company  would  be,  in  most  cases, 
of  such  an  order  as  would  exceed  the  assumed  cost  of 
buildings  which  might  have  been  found  upon  that  site, 
or  at  least  be  commensurate  with  such  cost.  Conditions 
will  be  found,  however,  in  the  valuation  of  public  util- 
ities wherein  a  rigid  adherence  to  such  a  method  would 
lead  to  absurdities.  Thus,  a  gas  plant  may  still  exist 
upon  a  site  which  has  become  surrounded  with  buildings 
of  the  highest  grade.  Every  condition  of  the  business 
may  indicate  that  it  would  have  been  wiser  to  have  util- 
ized land  situated  elsewhere.  The  value  of  the  naked 
land  will  be  its  fair  market  value,  but  it  would  be  mani- 
festly absurd  to  contend  that  such  a  value  should  be 
increased  still  further  by  the  cost  of  assumed  high  grade 
buildings  which  might  be  found  upon  the  land,  and  would 
have  to  be  destroyed  to  make  way  for  the  gas  plant. 

Probably  the  best  possible  illustration  of  such  an 
extreme  case  is  found  in  a  recent  case  before  a  Public 
Service  Commission.  The  Metropolitan  Company  (a 
street  railway  company)  owned  a  whole  block  upon  which 
it  had  built  a  one-story  car  barn  employed  in  large  part 
for  the  storage  of  cars  not  in  use.  This  property  was 
surrounded  by  land  which  had  been  greatly  improved  by 
the  erection  of  large  and  valuable  buildings.  The  Com- 
pany, following  the  principles  of  valuation  above  enun- 
ciated, claimed  that  the  value  of  the  naked  land  should  be 
enhanced  by  the  value  of  such  higher  grade  buildings  as 
would  probably  have  been  found  upon  the  land  if  the 
same  property,  as  now  existed,  had  to  be  replaced  to-day. 
In  answer  to  this  claim,  the  Commission  said,  "If  this 
theory  be  sound,  then  when  the  block  comes  to  be  entirely 
surrounded  with  buildings  of  fifteen  or  twenty  stories 
(that  is  the  tendency  in  that  district),  the  capitalizable 


DETERMINATION  OF  REPLACEMENT  COST  67 

value  of  that  land  will  be  not  only  the  fair  market  value 
of  the  land  itself,  but  that  value  plus  the  cost  of  these 
ten,  fifteen  or  twenty  story  buildings,  upon  the  assump- 
tion that  '  such  buildings  would  be  cleared  off.'  .  .  .  The 
Commission  does  not  accept  any  such  theory  as  proper 
or  as  affording  the  basis  for  determining  the  reasonable 
value  of  the  land,  and  no  precedents  or  court  decisions 
have  been  cited  to  support  it.  ...  Even  from  the 
standpoint  of  a  new  company  which  would  undertake  to 
reproduce  a  system  like  the  Metropolitan,  it  is  incon- 
ceivable that  a  thrifty  company  would  recommend  the 
purchase  of  a  whole  block  and  the  removal  of  fine,  expen- 
sive buildings  in  order  that  it  may  be  used  in  large  part 
to  store  cars  not  in  use."  l 

It  may  be  contended  that,  as  the  prices  of  land  have 
increased  in  most  places  in  the  United  States  very  greatly, 
the  cost  of  land  as  determined  by  the  method  described 
above  will  not  bear  any  relation  to  its  original  cost, 
particularly  if  the  cost  of  the  naked  land  is  enhanced  by 
the  cost  of  buildings,  possibly  of  a  high  grade  of  construc- 
tion, which  may  be  characteristic  of  the  development 
of  real  estate  in  that  locality. 

This  argument  was  presented  in  the  report  of  the  Rail- 
road Commission  of  Minnesota,  wherein  it  was  said: 

"Another  important  work  in  connection  with  valuing  the 
properties,  to  be  undertaken  by  the  Commission,  is  to  establish 
the  original  cost  of  the  lands  to  the  railway  companies.  It  must 
be  apparent  to  all  that  if  the  constantly  increasing  value  of 
railroad  properties  is  to  be  taken  as  the  basis  for  computing 
proper  returns,  without  regard  to  the  original  cost  of  the  same, 
it  is  only  a  matter  of  time  when  transportation  companies  will, 
by  absorption,  own  a  disproportionate  share  of  the  wealth  of 
the  country."  2 

1  In  re  Metropolitan  St.  Ry.  Co.,   N.  Y.  P.  S.  C.  Rpts.,  1st  Dist., 
Vol.  Ill,  p.  139.     (1912). 

2  Report  Railroad  Commission  of  Minnesota,  1908.     Supplement,  p.  v. 


68  PUBLIC  UTILITIES 

It  is  true  that  there  may  be  a  great  enhancement  in 
value  in  some  cases  but,  because  this  higher  value  is  made 
a  part  of  the  replacement  cost,  it  does  not  mean  that  this 
is  the  figure  which  is  to  be  used  ultimately  as  the  true 
present  value  of  the  plant.  The  court  will  be  furnished 
with  the  original  cost  and  the  undertaking  is  entitled  to 
the  normal  increment  which  has  arisen  from  the  increas- 
ing values  such  as  have  just  been  discussed — " within 
reason."  The  replacement  cost  must  represent  what  it 
would  actually  cost  the  undertaking  or  the  public  to-day 
to  acquire  this  same  land,  if  it  had  to  do  so  at  the  present 
time,  and  this  replacement  cost  is  the  figure  to  be  pre- 
sented to  the  court  for  what,  in  the  opinion  of  the  court, 
it  may  be  worth  as  evidence  toward  the  final  true  present 
value. 

52.  Cost  of  buildings.  —  The  value  of  buildings  should 
be  determined  by  experts  familiar  with  costs  of  construct- 
ing similar  buildings  in  that  locality  and  should  be  de- 
termined by  an  inspection  and  detailed  inventory  and 
appraisal  of  all  the  material  and  labor  which  would  be 
required  to  construct  a  new  building  identical  with 
that  in  existence. 


CHAPTER  IV 

VALUE   AS   GOING   CONCERN 

53.  Value  inherent  in  an  operating  plant. 

54.  Value  of  plant  in  use  dependent  upon  purpose  of  appraisal. 

55.  Fundamental  conception  of  value  inherent  in  "live  plant." 

56.  Capitalization  of  present  net  earnings. 

57.  Capitalization  of  present  and  anticipated  net  earnings. 

58.  Value  not  dependent  upon  cost  alone. 

59.  Capitalization  of  profits. 

60.  Analytical  methods  of  determining  value  inherent  in  a  live  plant. 

61.  Wisconsin  method. 

62.  Reproduction  of  net  earnings  method. 

63.  Doubt  as  to  inclusion  of  going  value  in  rate  cases. 

64.  General  consideration  of  value  inherent  in  a  live  plant. 

65.  Practical  usefulness  of  methods  of  determining  value  in  live  plant. 

53.  Value    inherent    in    an    operating    plant.  —  The 

replacement  cost,  as  derived  by  the  methods  which  have 
just  been  described,  shows  simply  the  cost  of  the  physical 
plant  new  as  of  the  present  time,  that  is  to  say,  the  pres- 
ent cost  of  reproducing  the  "bare  bones"  of  the  plant. 
That  the  value  of  the  property  of  an  undertaking  is 
greater  than  this  has  become  generally  recognized,  as  was 
shown  by  the  decision  of  Judge  Lurton  already  quoted. 
There  have  been  many  decisions  of  the  same  tenor,  a  few 
of  the  more  important  of  which  will  be  quoted :  — 
Mr.  Justice  Brewer  said: 

"The  original  cost  of  the  construction  cannot  control,  for 
' original  cost'  and  ' present  value '  are  not  equivalent  terms. 
Nor  would  the  mere  cost  of  reproducing  the  waterworks  plant 
be  a  fair  test,  because  that  does  not  take  into  account  the  value 
which  flows  from  the  established  connections  between  the 
pipes  and  the  buildings  of  the  city.  It  is  obvious  that  the  mere 
cost  of  purchasing  the  land,  constructing  the  buildings,  putting 
in  the  machinery,  and  laying  the  pipes  in  the  streets  —  in  other 


70  PUBLIC  UTILITIES 

words,  the  cost  of  reproduction  —  does  not  give  the  value  of 
the  property  as  it  is  to-day.  A  completed  system  of  water- 
works, such  as  the  company  has,  without  a  single  connection 
between  the  pipes  in  the  streets  and  the  buildings  of  the  city, 
would  be  a  property  of  much  less  value  than  that  system  con- 
nected, as  it  is,  with  so  many  buildings,  and  earning,  in  con- 
sequence thereof,  the  money  which  it  does  earn.  The  fact 
that  it  is  a  system  in  operation,  not  only  with  a  capacity 
to  supply  the  city,  but  actually  supplying  many  buildings 
in  the  city,  —  not  only  with  a  capacity  to  earn,  but  actually 
earning,  —  makes  it  true  that  '  the  fair  and  equitable  value ' 
is  something  in  excess  of  the  cost  of  reproduction.  .  .  .  The 
city,  by  this  purchase,  steps  into  possession  of  a  waterworks 
plant,  —  not  merely  a  completed  system  for  bringing  water 
to  the  city,  and  distributing  it  through  pipes  placed  in  the 
streets,  but  a  system  already  earning  a  large  income  by  virtue 
of  having  secured  connections  between  the  pipes  in  the  streets 
and  a  multitude  of  private  buildings.  It  steps  into  pos- 
session of  a  property  which  not  only  has  the  ability  to  earn, 
but  is  in  fact  earning.  It  should  pay  therefor  not  merely  the 
value  of  a  system  which  might  be  made  to  earn,  but  that  of  a 
system  which  does  earn."  1 

"It  is  plain  that  the  real,  commercial,  market  value  of  the 
property  of  the  water  company  is,  or  may  be,  in  fact,  greater 
than  'the  cost  of  duplication,  less  depreciation,  of  the  differ- 
ent features  of  the  physical  plant.'  Take,  for  example,  a 
manufacturing  plant :  Suppose  a  manufacturing  plant  has  been 
established  for  some  ten  years  and  is  doing  a  good  business  and 
is  sold  as  a  going  concern;  it  will  sell  for  more  on  the  market 
than  a  similar  plant  reproduced  physically  would  sell  for 
immediately  on  its  completion,  before  it  had  acquired  any 
business."  2 

"The  defendants,  in  request  9,  ask  that  in  determining  the 
amount  to  be  added  to  structure  value,  in  consideration  of  the 
fact  that  the  system  is  a  going  concern,  the  appraisers  should 
consider,  among  other  things,  the  present  efficiency  of  the  sys- 
tem, the  length  of  time  necessary  to  construct  the  same  de 
novo,  the  time  and  cost  needed  after  construction  to  develop 
such  new  system  to  the  level  of  the  present  one  in  respect  to 

1  National  Water  Works  Co.  v.  Kansas  City,  62  Fed.  865  (1894). 

8  Gloucester  Water  Supply  Co.  v.  City  of  Gloucester,  179  Mass.  382  (1901) . 


VALUE  AS  GOING  CONCERN  71 

business  and  income,  and  the  added  net  incomes  and  profits, 
if  any,  which,  by  its  acquirement  as  such  going  concern,  would 
accrue  to  a  purchaser  during  the  time  required  for  such  new 
construction,  and  for  such  development  of  business  and  income. 
We  think  this  instruction  should  be  given.  These  are  all 
proper  matters  for  consideration  'among  other  things/  They 
are  not  controlling.  Their  weight  and  value  depend  upon  the 
varying  circumstances  of  each  particular  case.  Of  course  a 
plant,  as  such,  already  equipped  for  business,  is  worth  more, 
if  the  business  be  a  profitable  one,  than  the  mere  cost  of  con- 
struction." l 

These  decisions  clearly  indicate  that  there  is  inherent 
in  a  plant  a  value  over  and  above  its  replacement  cost. 
"It  is  the  value  of  the  structure  as  being  used"  that 
must  be  sought  rather  than  the  value  of  the  physical  plant 
ready  to  be  used  but  not  productive. 

54.  Value  of  plant  in  use  dependent  upon  purpose  of 
appraisal.  —  Thus  far  in  the  present  discussion  of  valua- 
tion of  public  utilities,  no  distinction  has  been  made  as 
to  the  purpose  for  which  the  appraisal  was  designed.  The 
replacement  cost  will  be  unchanged  whatever  the  object 
of  the  investigation  as  to  value  and  the  methods,  which 
have  been  outlined  for  the  purpose  of  determining  replace- 
ment costs,  can  be  used  for  all  cases.  This  general 
treatment  cannot  be  followed  when  the  value  inherent 
in  a  plant  in  service  is  to  be  determined.  This  distinction 
arises  from  the  necessity  of  determining  this  value  by 
considerations  of  the  returns  which  arise  from  the  opera- 
tion of  the  plant,  and  the  fact  that  it  is  within  the  power 
of  the  State  to  exercise  such  a  control  over  the  rates 
charged  by  a  public  utility  as  to  make  the  return  an  uncer- 
tain quantity.  Thus,  this  value  inherent  in  a  plant  in  use 
may  be  one  thing  where  the  appraisal  is  for  the  purpose 
of  determining  a  basis  for  taxation,  another  where  a  con- 
sideration of  a  statutory  rate  is  involved  and  another 

1  Kennebec  Water  District  v.  City  of  Waterville,  54  Atl.  19  (1902). 


72  PUBLIC  UTILITIES 

when  the  object  is  the  determination  of  a  fair  selling 
price. 

55.  Fundamental  conception  of  value  inherent  in 
"live  plant."  —  The  fundamental  conception  of  the 
value  inherent  in  a  "live"  plant  is  contained  in  the  fol- 
lowing ruling: 

"But  the  value  of  property  results  from  the  use  to  which  it 
is  put  and  varies  with  the  profitableness  of  that  use,  present 
and  prospective,  actual  and  anticipated.  There  is  no  pecu- 
niary value  outside  of  that  which  results  from  such  use."  1 

This  quotation  voices  the  spirit  of  the  business  man  and 
the  investor.  The  replacement  cost  is  but  one  element  in 
his  consideration  of  an  operating  property  and,  usually, 
it  is  of  secondary  importance  as  compared  with  the  return 
present  and  prospective  that  can  be  obtained  from  the 
property.  Should  the  net  return  capitalized  at  a  fair 
market  rate  show  a  value  greater  than  the  present  value 
of  the  physical  plant,  this  enhancement  in  value  is  the 
value  of  the  "  livening  f actor. "  It  matters  not  what  it 
arises  from,  the  value  is  there  and  the  plant  is  worth 
more  by  that  amount  than  the  cost  of  its  bare  bones. 

A  method  based  on  this  line  of  reasoning  can  be  used 
whenever  there  is  no  possibility  of  action  on  the  part  of 
the  community  toward  reducing  rates,  or  where  the  value 
is  desired  at  the  present  time  under  an  existing  schedule. 
It  is  a  method  which  can  be  used  for  this  reason  where 
the  value  of  the  property  is  desired  as  a  basis  for  taxa- 
tion. It  is  one  which  has  been  extensively  used  in  the 
past  in  valuations  where  the  replacement  cost  was  not 
determined.  This  method  has  been  elaborated  and  used 
in  some  of  the  most  important  valuations  of  the  prop- 
erties of  public  utilities  in  the  United  States.  It  may  be 
briefly  described  as  follows. 

1  Cleveland,  Cincinnati,  Chicago  and  St.  Louis  R.  R.  Co.  v.  Backus, 
154  U.  S.  445  (1894). 


VALUE  AS  GOING  CONCERN  73 

56.  Capitalization  of  present  net  earnings.  —  The 
method  about  to  be  described  was  employed  in  the  val- 
uation of  the  railroad  properties  in  the  State  of  Michigan 
in  1900.1  The  replacement  cost  of  the  physical  plant 
was  found  in  substantially  the  manner  already  described, 
including  in  this  figure  the  cost  of  land  and  material 
together  with  all  overhead  charges.  The  depreciation, 
which  the  plant  had  suffered,  was  found  also  with  great 
care,  and  the  difference  between  the  replacement  cost 
and  the  depreciation  was  called  the  "  present  value  of 
the  physical  property."  The  value  inherent  in  the  plant 
over  and  above  the  present  value  of  the  physical  property 
thus  derived  was  found  by  first  determining  the  total 
available  corporate  income.  This  was  done  by  subtract- 
ing from  the  gross  income  the  operating  expenses  and  the 
depreciation  reserves.  From  the  available  corporate 
income  thus  found  was  subtracted  a  sum  equal  to  "4 
per  cent  of  the  mean  value  of  the  physical  elements." 
This  last  sum  represents  the  interest  upon  the  present 
plant  investments,  i.e.,  interest  upon  the  present  value 
of  the  "bare  bones"  of  the  plant  as  derived  by  means  of 
the  replacement  cost.  The  remainder,  after  subtract- 
ing this  interest  charge,  was  capitalized  at  6  per  cent 
and  added  to  the  present  value  of  the  physical  plant  as 
the  value  inherent  in  the  plant  over  and  above  its  pres- 
ent physical  value.  The  question  of  taxes  upon  the 
property  as  an  annual  expense,  has  been  eliminated  from 
the  above  description  for  the  sake  of  clearness.] 

It  is  of  interest  to  note  that  this  method  shows  the 
value  of  the  physical  plant  with  as  near  an  approach  to 
accuracy  as  is  possible.  The  value  of  the  plant  as  an 
operating  organization  depends  upon  the  profitableness 
of  its  use,  " present  and  actual."  It  makes  no  recogni- 
tion of  the  value  attaching  to  its  use,  "  prospective  and 

1  Bulletin  21,  1905,  U.  S.  Dept.  of  Commerce  and  Labor,  p.  76. 


74  PUBLIC  UTILITIES 

anticipated."  Thus  if  there  is,  for  the  period  taken  as  a 
measure  of  profitableness,  no  remainder  after  subtract- 
ing the  interest  upon  the  present  value,  there  is  no  value 
inherent  in  the  property  over  and  above  the  present 
plant  value.  Theoretically,  if  there  is  shown  a  deficit 
the  value  of  the  plant  should  be  reduced  by  a  capitaliza- 
tion of  the  losses.  As  a  practical  matter  in  the  partic- 
ular investigation  described  above  this  was  not  done, 
the  minimum  value  of  the  property  being  taken  as  the 
value  of  the  physical  plant. 

By  this  method  no  attempt  is  made  to  analyze  the  rea- 
sons why  there  may  be  a  special  value  inherent  in  the 
operating  property.  The  plant  is  there.  It  is  earning 
more  than  its  legitimate  fixed  charges  and,  consequently, 
has  an  enlivening  value.  This  enhancement  in  value 
may  come  from  good  management,  strategical  position, 
from  the  development  arising  from  years  of  service, 
from  special  grant  or  franchises.  It  matters  not.  By 
reason  of  one  or  all  of  these  conditions,  the  property  is 
successful  and,  consequently,  has  inherent  value  as  an 
operating  organization. 

But  the  above  method  does  not  cover  all  of  the  condi- 
tions which  would  be  considered  by  a  business  man  look- 
ing into  the  value  of  a  property,  assuming  for  the  moment 
the  probable  continuance  of  existing  rates.  The  under- 
taking may  be  at  its  inception  and  have  special  strategic 
value  which  would  make  it  of  prospective  value.  The 
method  just  described  cares  only  for  the  existing  operat- 
ing conditions  and  as  such  may  be  useful  as  a  basis  for 
taxation  but  would  not  represent  the  value  naturally 
inherent  in  the  enterprise  and  thus  be  considered  fair  and 
just  for  a  case  of  sale.  Another  method  will  be  described 
wherein  an  attempt  has  been  made  to  recognize  not  only 
the  present,  but  " prospective  and  anticipated"  value  of 
the  property. 


VALUE  AS  GOING  CONCERN  75 

57.  Capitalization    of    present    and    anticipated    net 
earnings.  —  By  this  method  the  present  value  of  the 
physical  plant  is  determined  in  the  manner  described 
above,  and  the  value  inherent  in  the  plant  as  an  operat- 
ing concern  is  determined  by  finding  what  has  been  called 
the  market  value  of  the  property  wherein  recognition  of 
all  of  the  special  conditions  surrounding  the  plant  are 
considered  which  will  tend  to  affect  the  value  of  the 
property  as  a  producer  of  income.     The  exact  value  to  be 
thus  assigned  to  the  property  due  to  its  strategic  posi- 
tion is  arrived  at  by  a  more  or  less  arbitrary  exercise  of 
judgment  after  a  careful  consideration  of  all  favorable  and 
unfavorable  conditions  affecting  the  property.1 

Such  a  method  is  reasonable  and  fair  for  a  valuation 
for  taxation  or  sale  provided  it  is  possible  to  arrive  at  a 
proper  figure  which  will  be  just  to  the  community  and  to 
the  undertaking  by  a  simple  exercise  of  judgment  and 
without  a  formulated  procedure,  whereby  results  can  be 
obtained  for  all  cases  with  accuracy  and  without  contro- 
versy. It  does  not  seem  as  if  it  was  one  that  could  be 
of  general  use  owing  to  the  fact  that  it  requires  values 
to  be  assigned  on  the  basis  of  the  judgment  of  the  ap- 
praiser rather  than  of  the  court.  It  is  probable  that  there 
would  be  many  different  values  assigned  depending  upon 
the  personal  bias  of  the  appraiser. 

This  method  is  introduced  simply  to  show  the  recog- 
nition, which  has  been  held  in  some  of  the  most  impor- 
tant appraisals  which  have  been  made  in  this  country, 
of  definite  values  inherent  in  property,  both  present  and 
anticipated.  This  method  tacitly  accepts  the  continu- 
ance of  the  prevailing  rates. 

58.  Value  not  dependent  upon  cost  alone.  —  The  above 
two  methods  illustrate  the  real  value,  the  market  value, 

1  Valuation  of  Railways  in  Washington,  Railway  Age  Gazette,  Vol. 
48,  p.  359. 


76  PUBLIC  UTILITIES 

of  a  property  in  active  operation.  If  the  undertaking 
is  successfully  earning  a  return,  the  owners  feel  that  they 
are  entitled  to  such  return  and  that  it  is  due  to  natural 
value  inherent  in  the  property  which  they  have  created. 
They  incurred  the  hazard  of  starting  in  upon  a  new  enter- 
prise, in  many  cases  in  a  community  or  with  a  utility 
more  or  less  unknown.  The  community  itself  had  the 
right  to  provide  the  same  utility,  but  did  not  dare  or 
care  to  undertake  the  risk.  The  owners  had  to  borrow  or 
obtain  money  to  finance  the  enterprise.  In  most  cases 
it  was  necessary  to  issue  common  stock  as  a  bonus,  upon 
which  dividends  were  to  be  paid  when  the  return  became 
sufficient.  They  argue  that  no  progress  can  be  made  if 
an  ample  reward  is  not  afforded  to  the  men  who  have 
the  means,  skill  and  courage  to  enter  upon  such  pioneer 
work  and  make  it  successful.  To  them  this  value  in  a 
"live"  plant,  either  present  or  prospective,  is  their  reward 
and  should  be  made  a  distinct  element  in  the  value  of 
their  property. 

This  line  of  reasoning  has  been  used  in  the  determina- 
tion of  the  value  of  several  water  companies  in  cases  of 
condemnation,  and  is  of  great  interest  as  exemplifying 
the  recognition  of  this  inherent  value  in  a  successfully 
operating  property. 

59.  Capitalization  of  profits.  —  The  fact  that  the 
undertaking  is  furnishing  the  service  presupposes  that 
the  community  preferred  to  grant  the  privilege  to  operate 
to  others  rather  than  itself  incur  the  financial  risks  in- 
volved. At  some  time  prior  to  the  date  of  the  appraisal, 
the  undertaking  had  raised  the  money  required  to  build 
the  plant  and  to  operate  it,  had  constructed  the  plant  and 
taken  the  risk  involved  by  investing  its  money  in  a  new 
enterprise.  The  money  which  has  thus  been  tied  up  in 
the  new  utility  could  have  been  expected  to  earn  a  nor- 
mal rate  of  interest  if  invested  in  some  manner  involv- 


VALUE  AS  GOING  CONCERN  77 

ing  less  hazard.  The  undertaking  can  expect  properly 
and  is  entitled  legally  to  a  profit  over  and  above  the 
normal  interest  charges  on  the  money  which  had  beerr 
expended  in  the  new  enterprise. 

The  question  which  is  involved  in  any  special  case, 
therefore,  is  what  should  be  the  proper  ratio  of  profit  to 
the  interest  normally  required  on  bonds  or  loans  on  the 
property  of  enterprises  of  this  character.  Probably  in 
most  cases,  the  answer  to  this  question  must  be  given  by 
the  court.  The  appraiser  can  present  figures  for  inter- 
est and  profit,  determined  by  the  methods  described 
in  another  chapter.  If,  for  any  particular  case,  it  has 
been  found  that  the  interest  rate  upon  the  bonds  of  this 
undertaking  or  a  similar  undertaking  is  properly  5  per 
cent  and  that  a  return  of  7  per  cent  is  justifiable  for  an 
enterprise  of  this  character  in  the  locality  where  it  is  sit- 
uated, then  the  ratio  of  profit  is  40  per  cent. 

Following  out  this  line  of  reasoning,  it  would  appear 
that,  in  a  case  where  the  enterprise  itself  has  provided 
all  of  the  money  required,  the  value  of  the  property 
when  completed  was  greater  than  the  actual  cost  by  an 
amount  equivalent  to  the  capitalization  of  the  profits. 
Thus,  for  the  above  case,  if  the  property  had  cost 
$100,000.00,  its  value  could  be  considered  to  be 
$140,000.00. 

At  the  time  of  an  appraisal  it  will  not  be  the  original 
cost  which  will  be  taken  as  the  basis  of  the  profit  incre- 
ment, but  rather  what  it  would  cost  at  the  present  time 
to  reproduce  the  property  of  the  undertaking;  in  other 
words,  it  would  be  the  replacement  cost  from  which  no 
depreciation  is  deducted,  as  it  is  the  value  of  the  property 
new  as  of  the  present  time. 

Thus  the  replacement  cost  plus  the  profit  increment 
may  be  considered  as  showing  the  maximum  value  that 
can  be  given  to  the  property  of  an  undertaking  as  it  fur- 


78  PUBLIC  UTILITIES 

nishes  a  value  equal  to  the  cost  at  the  present  time  of  the 
same  plant  new  and  to  such  value  is  added  an  amount 
which  can  be  considered  as  the  maximum  which  it  is  fair 
and  right  to  award  to  an  undertaking  for  its  skill  and 
enterprise  in  providing  the  utility  for  the  community. 

As  just  stated,  the  figure  thus  derived  is  a  maximum; 
it  must  be  reduced  by  amounts  representing  the  diminu- 
tion in  value  of  the  plant  arising  from  its  depreciation  and 
from  its  inefficiency.  This  reduced  value  is  presented 
as  a  tentative  present  value  of  the  "live"  property  of 
the  undertaking. 

60.  Analytical  methods  of  determining  value  inherent 
in  a  live  plant.  —  In  the  methods  thus  far  discussed,  the 
value  inherent  in  a  live  plant  has  been  derived  without 
any  attempt  being  made  to  assign  definite  values  to  the 
characteristics  of  the  plant  which  operate  to  make  the 
operating  organization  successful  and  capable  of  pro- 
ducing an  adequate  return.  The  operating  organiza- 
tion is  there  and  has  been  developed,  is  furnishing  service 
to  the  public  and  the  live  plant  is  of  more  value  than  it 
would  be  if  it  were  not  furnishing  service. 

But  in  many  cases  appraisers  have  attempted  to 
analyze  the  value  inherent  in  the  life-giving  character- 
istics of  an  operating  property,  and  by  such  dissection 
to  assign  definite  values  not  only  to  the  dead  plant  but  to 
the  organism  which  may  be  claimed  to  give  it  life.  Thus 
the  physical  plant,  called  the  tangible  property,  is  dis- 
tinguished from  the  vitalizing  factor,  called  intangible 
property,  and  intangible  property,  when  dissected,  is 
claimed  by  many  to  be  composed  of  special  life-giving 
attributes,  such  as  good  will,  franchise  rights  and  going 
value. 

Good  will  and  franchise  values  will  be  considered  more 
in  detail  later.  It  is  sufficient  here  to  say  that  the  courts 
have  ruled  that  for  a  public  utility  no  value  can  be  as- 


VALUE  AS  GOING  CONCERN          79 

signed  to  good  will,  and  that  except  where  there  is  a  defi- 
nite agreement,  beyond  the  right  to  operate,  franchises 
have  no  value  that  can  be  capitalized  except  what  may" 
have  been  paid  for  them  or  may  have  been  allowed  for 
them  by  some  prior  decree  of  the  court. 

Going  value  or  value  as  a  going  concern  has  been  re- 
garded by  many  experts  simply  as  what  it  had  cost  the 
undertaking  to  establish  a  profitable  business  or  what  it 
would  cost  to-day  to  reproduce  its  present  business.  It 
is  seen  that  as  a  result  of  this  analytical  treatment  there 
can  be  presented  a  figure  representative  of  the  value  exist- 
ing in  but  one  enlivening  attribute  of  a  successfully  oper- 
ating property,  that  of  value  as  a  going  concern.  Two 
methods  have  been  evolved  for  finding  this  value  and 
will  be  briefly  described. 

61.  Wisconsin  method.  —  The  method  about  to  be 
described  is  called  the  Wisconsin  method  for  the  reason 
that  it  is  the  one  which  has  been  used  by  the  Wisconsin 
Commission  in  all  valuations  made  by  it  for  all  purposes. 

In  explanation  of  this  method,  a  portion  of  one  of  the 
decisions  of  the  Wisconsin  Commission  may  be  quoted: 

"If  property  is  devoted  to  the  public  use,  and  reasonable 
care  has  been  exercised  in  all  the  phases  of  its  management,  but 
the  owners  have  not  received  a  fair  return  during  the  earlier 
years  of  the  operation  of  the  plant  in  which  the  property  is 
used  for  the  convenience  of  the  public,  the  deficit  thus  incurred 
must  be  made  up  out  of  later  earnings,  in  so  far  as  this  is  com- 
mercially possible  and  expedient.  In  other  words,  every  effort 
honestly  put  forth,  every  dollar  properly  expended,  and  every 
obligation  legitimately  incurred  in  the  establishment  of  an  effi- 
cient public  utility  business  must  be  taken  into  consideration 
in  the  making  of  rates  for  such  business.  Collectively  the  ele- 
ments just  referred  to  may  be  designated  by  the  term  going 
value,  and  in  this  sense  there  can  be  no  question  regarding  the 
propriety  and  justice  of  admitting  going  value  as  a  considera- 
tion in  the  determination  of  rates.  Whether  this  going  value 
should  be  made  a  part  of  the  permanent  capitalization  of  the 


80  PUBLIC  UTILITIES 

plant,  or  provided  for  by  means  of  a  sinking  or  other  fund,  is  a 
matter  to  be  decided  on  the  facts  in  each  particular  case."  1 

Authority  is  given  to  this  method  by  a  recent  decision 
of  the  Supreme  Court  of  Oklahoma. 

"Few  industries,  if  any,  involving  an  investment  of  $90,000 
or  more,  can  be  made  self-sustaining  from  the  first  day  of  their 
operation.  The  uncontradicted  evidence  in  this  case  discloses 
that  appellant's  plant  for  the  years  preceding  the  first  hearing, 
failed  to  produce  revenue  sufficient  for  operating  expenses, 
current  repair,  and  lay  aside  an  amount  for  depreciation. 
During  the  time  of  development  there  is  a  loss  of  money  actu- 
ally expended  and  of  dividends  upon  the  property  invested. 
How  shall  this  be  taken  care  of?  Must  it  be  borne  by  the 
owner  of  the  plant?  Or  by  the  initial  customers?  Or  shall  it 
be  treated  as  part  of  the  investment  or  value  of  the  plant  con- 
stituting the  basis  upon  which  charges  shall  be  made  to  all 
customers  who  receive  the  benefits  from  the  increased  service 
rendering  power  of  the  plant  by  reason  of  these  expenditures? 
It  seems  that  the  last  solution  is  the  logical,  just  and  correct 
one.  If  rates  were  to  be  charged  from  the  beginning  so  as  to 
cover  these  expenditures  and  earn  a  dividend  from  the  time 
a  plant  is  first  operated,  the  rate  to  the  first  customers  would 
be  in  many  instances,  if  not  in  all,  so  exorbitant  as  to  be  pro- 
hibitive and  would  be  so  at  the  time  when  the  plant  could  be 
of  least  service  to  them.  On  the  other  hand,  the  public  can- 
not expect  as  a  business  proposition  or  demand  as  a  legal  right 
that  this  loss  shall  be  borne  by  him  who  furnishes  the  service; 
for,  investors  in  public  service  property  make  such  investments 
for  the  return  they  will  yield;  and,  if  the  law  required  that  a 
portion  of  the  investments  shall  never  yield  any  return,  but 
shall  be  a  total  loss  to  the  investor,  capital  would  unwillingly 
be  placed  into  such  class  of  investments;  but  the  law,  in  our 
opinion,  does  not  so  require.  Private  property  can  no  more 
be  taken  in  this  method  for  public  use  without  compensation, 
than  by  any  other  method.  When  the  use  of  the  property 
and  the  expenditures  made  during  the  nonexpense-paying  and 
nondividend-paying  period  of  the  plant  are  treated  as  an  ele- 
ment of  the  value  of  the  property  upon  which  fair  returns  shall 

1  Wis.  R.  R.  Com.  Rpts.,  Vol.  4,  p.  61. 


VALUE  AS  GOING  CONCERN  81 

be  allowed,  then  the  burden  is  distributed  among  those  who 
receive  the  benefits  of  the  expenditures  and  the  use  of  the 
property  in  its  enhanced  value."  i 

Practically  no  undertaking  begins  earning  a  warrant- 
able return  upon  its  investment  from  its  inception.  There 
must  be  inevitably  money  expended  not  only  in  the  admin- 
istration and  the  operation  of  the  business  but  in  adver- 
tising, canvassing  and  similar  work  required  to  attract 
users  of  the  utility.  In  most  cases  these  expenses  will 
be  considerable,  for  the  reason  that  the  public  will  be 
unfamiliar  with  the  service  and  must  be  educated  to  its 
use.  In  this  respect,  in  many  cases,  the  original  cost  will 
be  greater  than  similar  expenses  figured  under  the  repro- 
duction value  of  a  replacing  plant. 

The  Wisconsin  Commission  evidently  has  felt  that  the 
value  imparted  to  the  dead  plant  by  making  it  actively 
in  operation  was  to  be  measured  by  what  it  had  cost  the 
company  to  acquire  a  successful  and  remunerative  busi- 
ness. In  other  words,  this  increment  of  value  over  and 
above  the  replacement  cost  is  the  original  cost  of  making 
the  concern  productive  of  a  fair  return. 

There  are  two  doubts  which  arise  as  to  whether  this 
method  is  one  which  is  free  from  such  difficulties  in  its 
practical  operation  as  to  commend  it  for  general  use. 
The  first  is  that  pointed  out  by  the  Court  in  the  Spring 
Valley  Case,  wherein  this  method  was  employed  by  one 
or  more  experts  to  derive  the  increment  in  value  in  a  live 
plant,  in  which  it  was  said: 

"This  estimate  is  open  to  the  objection  that  the  deficiency 
of  revenue  may  have  been  due  to  extravagant  or  wasteful 
management.  The  company  may  have  purchased  a  plant 
larger  and  more  expensive  than  necessary;  current  rates  of 
interest  may  have  been  abnormally  high;  many  causes  which 

1  Supreme  Court  of  Oklahoma  —  Pioneer  Tel.  &  Tel.  Co.  v.  E.  H. 
Westenhaver,  29  Oklahoma, p.  447,  (1911). 


82  PUBLIC  UTILITIES 

have  absolutely  no  relation  to  the  value  of  the  company's 
business  now  as  a  going  concern  may  have  increased  or  dimin- 
ished the  deficiency  in  revenue.  Furthermore,  if  it  be  con- 
ceded that  early  deficiency  of  revenue  is  the  proper  measure  of 
value  for  the  present  going  business,  then  it  follows  that,  the 
greater  the  deficiency  and  the  more  unprofitable  the  business, 
the  greater  the  present  value  of  the  going  concern;  and,  if  the 
business  had  yielded  large  profits  from  its  very  inception,  the 
going  business  to-day  would  be  worthless."  1 

The  Court  refused  in  this  case  to  use  figures  derived  in 
this  manner. 

The  Wisconsin  Commission  has  fully  appreciated  the 
above  mentioned  difficulties  which  are  present  in  this  plan, 
and  in  its  later  decisions  has  indicated  not  only  the 
factors  which  may  tend  to  distort  results  but  has  said: 

"When,  however,  conditions,  which  may  be  unusual  or  abnor- 
mal for  any  reason,  are  encountered  in  any  particular  investi- 
gation, they  must  be  first  eliminated  or  disregarded  before  a 
reliable  result  can  be  reached."  2 

The  second  doubt  lies  in  the  fact  that,  what  is  needed 
by  the  Court  is  the  value  of  the  entire  property  of  the 
company  at  the  present  time,  and,  to  aid  him  in  forming 
a  decision  as  to  what  that  value  may  be,  he  requires  the 
original  cost  and  the  replacement  cost.  Logically  the 
increment  in  value  derived  by  the  Wisconsin  method  is 
the  original  cost  of  obtaining  a  successful  business  and  is 
a  proper  increment  of  the  original  cost  of  the  property. 
It  is  not  a  figure  representative  in  any  way  of  what  it  would 
cost  to-day  to  reproduce  the  business.  In  a  case  of  sale, 
where  the  buyer  had  the  option  of  either  building  up  a 
new  enterprise  or  of  acquiring  an  existing  one,  he  would 
not  be  concerned  at  all  with  what  it  had  cost  the  present 

1  Spring  Valley  Water  Co.  0.  City  and  County  of  San  Francisco,  165 
Fed.  697, 1908. 

2  Wis.  R.  R.  Com.  Rpts.,  Vol.  5,  p.  277. 

See  N.  Y.  P.  S.  C.  1st  Dist.  Case  1398,  Feb.  13,  1912. 


VALUE  AS  GOING  CONCERN  83 

owners  for  their  property  but  rather  with  what  it  would 
cost  him  to-day  to  acquire  a  similar  property,  —  plant 
and  business. 

62.  Reproduction  of  net  earnings  method.  —  This 
method  was  designed  evidently  to  correct  the  difficulty 
inherent  in  that  just  described  and  is  designed  to  show 
what  it  would  cost  to  reproduce  the  business  at  the  pres- 
ent time.  It  was  first  used  in  determining  the  value  of 
the  property  of  the  Dubuque  Water  Works  in  a  case  of 
sale,  and  has  been  employed  frequently  since  that  time  in 
the  valuation  of  waterworks  in  cases  of  condemnation.1 
This  method  has  been  elaborated  and  described  in  detail 
by  Messrs.  Leonard  Metcalf  and  John  W.  Alvord,  whose 
original  papers  should  be  studied  for  a  full  understanding 
of  the  figuring  involved.2 

Briefly  stated,  this  method  consists  in  a  determination 
of  the  cost  of  reproducing  the  business  of  the  undertak- 
ing. All  of  the  assumptions  above  made  as  to  period  of 
construction  and  sums  invested  yearly  in  plant,  as  well 
as  probable  dates  when  completed  portions  of  the  plant 
are  turned  over  to  operating  departments,  hold.  The 
development  of  the  business  is  assumed  to  cover  not  only 
the  period  of  the  construction  of  the  plant  but  some 
period  of  time,  after  the  date  of  the  completion  of  the 
construction  work,  which,  it  is  estimated,  will  be  sufficient 
for  the  new  hypothetical  replacing  plant  to  be  able  to  have 
acquired  a  business  equal  to  that  of  the  undertaking  using 
the  existing  going  plant.  The  amount  of  business  which 
the  imaginary  or  comparative  plant  can  obtain  during 
each  year  of  the  assumed  development  period  of  the 
business  is  estimated  and  computed. 

It  is  usual  to  assume  that  the  comparative  plant  starts 

1  See  Proceedings  American  Water  Works  Association,  1909,  p.  184. 

2  See  Transactions  American  Society  of  Civil  Engineers,  1911,  Vol.  73, 
p.  326. 


84  PUBLIC  UTILITIES 

at  the  date  of  valuation  and  assumptions  must  be  made 
as  to  the  probable  business  of  both  the  existing  and 
comparative  plants. 

"The  sum  of  the  present  worths  of  the_  annual  excess  in  net 
return  of  the  existing  plant  over  the  hypothetical  or  com- 
parative plant,  in  the  period  of  years  from  the  date  of  taking  to 
the  time  when  the  earnings  of  the  comparative  plant  are 
assumed  to  become  identical  with  those  of  the  existing  plant, 
represents  the  going  value  of  the  existing  plant." 

The  above  method  has  been  criticised  as  depending 
very  largely  upon  the  assumptions  of  the  appraisers  as 
to  the  length  of  time  required  by  a  hypothetical  plant 
to  reproduce  the  present  earning  power  of  the  existing 
plant.  There  can  be  no  question  that  this  assump- 
tion must  be  based  upon  the  judgment  of  an  appraiser 
especially  familiar  with  the  business  and  business  condi- 
tions affecting  the  utility  under  valuation.  But,  it  can 
be  seriously  questioned  whether  an  opinion  of  a  compe- 
tent expert  on  this  matter  involves  any  greater  possibil- 
ity of  errors  than  are  present  in  making  the  assumptions 
needed  in  determining  the  replacement  cost  and  depre- 
ciation of  the  distinctly  physical  portion  of  the  plant. 
The  appraiser  has  at  his  command  figures  showing  the 
earnings  and  operating  expenses  of  the  undertaking  for 
as  many  years  in  the  past  as  may  be  necessary.  No 
assumption  is  made  as  to  the  familiarity  of  the  public 
with  the  use  of  the  utility  sold.  Thus  it  may  have  taken 
many  years  for  the  existing  undertaking  to  have  brought 
the  public  to  an  appreciation  of  the  value  or  convenience 
of  the  utility  and,  in  consequence,  the  development  of 
the  existing  service  may  have  been  slow.  For  a  deter- 
mination of  the  development  of  the  hypothetical  busi- 
ness, the  present  conditions  are  assumed  and  no  more 
time  assumed  than  would  be  necessary  to  attract  users 
than  would  be  the  case  if  the  present  undertaking  ceased 


VALUE  AS  GOING  CONCERN  85 

to  exist  and  a  new  one  continued  in  its  stead.  The  exist- 
ing undertaking  is  in  no  way  considered  as  a  competitor 
of  the  hypothetical  replacing  undertaking. 

From  what  has  been  said  above,  this  method  of  deter- 
mining going  concern  value  is  simply  an  extension,  to  the 
business  of  the  undertaking,  of  the  same  general  methods 
and  of  many  of  the  same  assumptions  as  were  used  in  a 
determination  of  the  replacement  cost  of  the  physical 
plant,  and  can  be  employed,  in  most  cases,  with  approxi- 
mately the  same  degree  of  accuracy. 

63.  Doubt  as  to  inclusion  of  going  value  in  rate  cases. 
-  The  above  two  methods  assign  a  value,  as  a  going 
concern,  equivalent  to  the  cost  of  building  up  the  busi- 
ness of  the  undertaking.  But  some  doubt  has  been  cast 
upon  even  this  value  when  the  valuation  is  made  for  the 
purpose  of  determining  the  equity  of  a  statutory  rate. 
This  doubt  is  clearly  manifested  in  Judge  Lurton's  deci- 
sion which  has  been  quoted  already,  in  which  he  said:  — 

"No  such  question,"  value  as  going  concern,  "was  consid- 
ered in  either  Knoxville  v.  Knoxville  Water  Company  (212  U.  S. 
1)  or  in  Willcox  v.  Consolidated  Gas  Company  (212  U.  S.  19). 
Both  cases  were  rate  cases,  and  did  not  concern  the  ascertain- 
ment of  value  under  contracts  of  sale."  1 

Mr.  Justice  Weaver  said  in  another  case:  — 

"By  'going  value'  we  understand  is  meant  that  value  which 
arises  from  having  an  established  'going'  business.  While 
not  the  exact  equivalent  of  'good  will/  as  applied  in  ordinary 
business,  it  is  of  a  somewhat  similar  nature,  and  attaches  to 
the  business,  rather  than  to  the  property  employed  in  such 
business.  The  fact  that  the  business  is  established  is,  of  course, 
a  material  fact  in  ascertaining  the  value  of  the  plant,  and  espe- 
cially is  this  true  where  the  property  is  being  estimated  for  the 
purposes  of  sale  or  condemnation;  but  as  a  basis  for  estimating 
profits  its  significance  is  less  apparent."  2 

1  City  of  Omaha  v.  Omaha  Water  Company,  218  U.  S.  180  (1909). 
*  Cedar  Rapids  Water  Co.  v.  Cedar  Rapids,  118  Iowa,  262. 


86  PUBLIC  UTILITIES 

While  these  decisions  appear  to  afford  some  reason  for 
doubt  upon  this  matter,  a  review  of  the  facts  relative  to 
the  above  cited  cases  will  throw  much  light  as  to  present 
practice.  In  the  Knoxville  case  the  Master  allowed  a 
valuation  of  $608,000.00  made  up  of  an  appraisement  in 
minute  detail  of  the  tangible  property  with  an  added 
amount  $10,000  for  "  organization,  promotion,  etc.,"  and 
$60,000  for  "  going  concern."  The  court  refused  to  pass 
upon  the  propriety  of  these  two  items,  leaving  that  ques- 
tion to  be  considered  "  when  it  necessarily  arises."  It 
assumed  without  deciding  that  they  were  properly  added. 

The  decision  of  the  Supreme  Court  of  the  State  of  Okla- 
homa in  the  Enid  case,  a  case  involving  the  equity  of  a 
statutory  rate,  which  was  quoted  above,  definitely  in- 
cluded going  value. 

"  Whatever  discoverable  value  may  attach  to  the  concern 
as  a  going  business  is  proper  to  be  considered  in  determining 
the  value  of  complainant's  plant  for  rate-fixing  purposes."  1 

To  the  engineer  and  to  those  familiar  with  the  cost 
which  must  be  inevitably  incurred  in  bringing  the  busi- 
ness of  an  undertaking  up  to  a  paying  basis,  it  seems  that 
"in  equity  it  cannot  be  doubted  that  going  value  should 
be  included  in  the  base  on  which  the  returns  are  predi- 
cated, if,  as  contended,  it  involves  real  cost  to  the  com- 
pany; for  the  company  must  be  permitted  to  earn  a  fair 
return  on  this  cost,  or  to  liquidate  it  in  some  way,  as 
otherwise  the  corporation  would  suffer  substantial  prop- 
erty loss  —  from  10  to  20  per  cent,  more  or  less,  of  the 
reproduction  cost  of  its  property.  This  would  be  con- 
trary to  public  policy,  for,  with  such  an  outlook,  capital 
would  not  enter  this  field  of  enterprise,  except  at  increased 
rates  of  return,  commensurate  with  this  added  hazard."2 

1  Spring  Valley  Water  Co.  v.  City  and  County  of  San  Francisco,  165 
Fed.  693,  (1908). 

2  Mr.  Leonard  Metcalf,  Trans.  Am.  Soc.  Civil  Engineers,  Vol.  LXXII, 
p.  256. 


VALUE  AS  GOING  CONCERN  87 

64.  General  consideration  of  value  inherent  in  a  live 
plant.  —  Probably  no  question  involved  in  the  appraisal 
of  the  property  of  a  public  utility  is  less  understood  by 
appraisers  and  the  public  at  large  at  the  present  time, 
than  this  of  the  value  of  a  live  plant  as  distinguished  from 
the  value  of  the  bare  bones  of  the  plant.  This  is  indicated 
by  the  widely  different  methods  above  described  which 
have  been  employed  by  different  experts  to  derive  such 
values.  That  there  may  be  such  an  inherent  value  has 
been  definitely  recognized  by  the  courts,  as  has  been  shown 
in  the  above  quoted  decisions.  The  insistence  upon  this 
value  and  the  fear  that  it  may  not  be  sufficiently  recog- 
nized are  the  bases  of  most  of  the  opposition  on  the  part  of 
the  management  and  owners  of  public  utilities  to  apprai- 
sals designed  to  determine  the  present  value  of  their  prop- 
erties, particularly  when  questions  of  rates  are  involved. 

Moreover,  it  must  be  admitted  that  errors  have  been 
made  by  appraisers  in  attempting  to  find  and  assign 
definite  values  to  possible  life  giving  or  earning  factors 
which  may  be  characteristic  of  a  successful  operating 
undertaking.  As  has  been  shown,  such  definite  values 
have  been  given  little  or  no  consideration  by  the  courts 
although  they  fully  recognize  the  value  inherent  in  the 
live  plant.  Thus  good  will,  and  franchise  value,  for  a 
public  service  corporation  have  been  ruled  to  be  incapable 
of  being  capitalized  in  the  case  of  public  service  corpora- 
tions and,  in  some  cases,  the  attempts  made  to  find  a 
so-called  going  value  have  not  been  accepted  by  the 
courts  as  definitely  established  figures. 

But  while  it  may  seem  that  the  exclusion  of  these  values 
has  been  definitely  ruled  by  the  courts,  still  we  have  the 
reiterated  authority  of  the  Supreme  Court  of  the  United 
States,  that  the  value  inherent  in  the  live  plant,  its  value 
as  a  going  concern,  is  a  definite  asset  of  a  public  utility 
undertaking. 


88  PUBLIC  UTILITIES 

As  will  be  shown  there  can  be  no  value  definitely  assign- 
able to  good  will  per  se  nor,  with  possible  exceptions  in 
special  cases,  to  franchises  per  se.  But  it  will  be  claimed, 
and  claimed  upon  reasonably  good  grounds,  that  for  an 
undertaking,  even  if  it  has  no  competitor,  its  ability  to 
earn  money  is  enhanced  by  the  possession  of  both  of  these 
attributes.  An  undertaking  that  is  furnishing  the  best 
possible  service,  is  prompt  and  courteous  in  its  dealings 
with  the  public,  that  has  adjusted  its  rates  voluntarily 
when  it  could  afford  to  do  so  and  has  been  liberal  and 
fair  in  the  treatment  of  its  employees,  has  what  may  be 
called  the  "good  will"  of  the  community.  Such  good 
will  in  reality  may  amount  to  nothing  more  than  a  free- 
dom from  an  imposition  by  the  public  authorities  of  rates 
productive  of  a  loss  of  revenue.  Although  such  good  will 
cannot  be  given  a  value  by  experts  nor  by  the  courts, 
yet  such  good  will  is  unquestionably  an  attribute  which 
enables  the  undertaking  to  earn  a  fair  return  over  and 
above  a  return  on  the  value  of  its  purely  physical  property. 

It  is  the  same  with  franchises.  The  plant  of  the  undertak- 
ing "is  not  only  a  structure,  and  a  structure  being  used,  but  it 
is  a  structure  built,  maintained,  and  used  by  authority  expressly 
granted  to  the  company  by  the  state;  that  is,  it  was  built  and 
is  maintained  and  used  by  virtue  of  a  franchise  or  franchises. 
The  structure  is  lawfully  in  existence,  and  may  rightfully  con- 
tinue to  be  used  as  a  going  concern  structure,  until  the  state 
determines  otherwise.  This  also  makes  the  structure  in  use 
more  valuable.  It  is  the  difference  between  a  structure  exist- 
ing by  sufferance  and  one  maintained  by  right.  The  franchise, 
however,  is  a  limited  one.  It  is  not  perpetual.  It  may  be 
recalled  by  the  state.  It  is  not  exclusive.  Other  and  com- 
peting franchises  may  be  granted.  It  is  not  absolute."  l 

The  above  decision  clearly  and  definitely  rules  that  a 
property,  operating  under  a  franchise,  is  more  valuable 

1  Brunswick  and  Topsham  Water  Dist.  v.  Maine  Water  Co.,  59  Atl 
539  (1905). 


VALUE  AS  GOING  CONCERN  89 

than  if  it  did  not  possess  this  attribute.  But  the  fran- 
chise per  se,  separated  from  the  plant,  cannot  be  given  a 
value  by  the  experts  nor  by  the  courts,  except,  as  will 
be  seen  later,  when  money  has  been  actually  paid  for  the 
rights  under  which  the  undertaking  is  operating.  This 
reasoning  is  fully  borne  out  by  the  following  ruling: 

"For  these  reasons  I  believe  that  on  principle  a  franchise 
should  be  held  to  have  no  value  except  that  arising  from  its 
use  as  a  shield  to  protect  those  investing  their  property  upon 
the  faith  thereof,  and  that,  considered  alone  and  apart  from 
the  property  which  it  renders  fruitful,  it  possesses  no  more 
economic  value  for  the  investor  than  does  an  actual  shield 
possess  fighting  value,  apart  from  the  soldier  who  bears  it."  1 

This  decision,  that  a  franchise  "considered  alone  and 
apart  from  the  property  which  it  renders  fruitful"  cannot 
be  given  a  definite  value,  brings  out  definitely  the  point 
that  an  analytical  discussion  of  the  attributes  of  a  live 
plant  is  fruitless.  This  point  is  accentuated  by  another 
ruling  on  this  matter. 

"It  were  better  ...  to  have  proceeded  along  the  lines  of 
.  .  .  the  doctrine  of  this  court,  that  there  can  be  no  such  sep- 
aration of  tangible  and  intangible  elements  which  will  furnish 
any  legitimate  basis  for  the  valuation  of  one  or  the  other.  As 
neither,  strictly  speaking,  is  required  to  be  valued,  but  only 
the  thing  which  the  two  in  combination  make,  why  attempt 
to  do  what  lays  the  very  basis  for  claims  which  are  illegitimate 
though  embarrassing?  The  departure  from  the  needful,  try- 
ing to  do  the  impracticable,  would  seem  to  be  worse  than  use- 
less. One  might  as  well  try  to  value  the  life-blood  of  a  horse, 
or  his  capacity  to  breathe,  as  try  to  place  a  value  upon  the 
visible  part  of  railroad  property  separate  from  its  rights,  fran- 
chises and  privileges."  2 

Yet,  while  it  must  be  admitted  by  all  that,  although 
such  factors  cannot  be  analytically  separated  from  the 

1  Consolidated  Gas  Co.  v.  City  of  New  York,  157  Fed.  874. 

2  Chicago  and  Northwestern  Railway  Co.  v.  The  State  (1906)  128  Wise. 
621. 


90  PUBLIC  UTILITIES 

property  as  a  whole,  each  is  a  factor  in  making  the  suc- 
cess of  the  undertaking  to  an  extent  not  measurable  by 
definite  figures.  Thus,  - 

"The  property  to  be  taken,  both  plant  and  franchises,  are 
to  be  appraised,  having  in  view  their  value  as  property  in  itself, 
and  their  value  as  a  source  of  income.  The  physical  property 
has  value  irrespective  of  the  franchise,  and  the  franchise  with- 
out reference  to  the  physical  property.  But  these  two  kinds 
of  value  practically  shade  into  each  other."  1 

"The  value  of  the  physical  elements  of  corporations,  or  bus- 
iness property,  is  made  up  largely  of  those  which  are  invisible. 
Sometimes  the  value  of  the  latter  exceeds  that  of  the  former 
in  that,  were  the  two  separated,  the  visible  things  in  the  disor- 
ganized condition  would  be  worth  less  than  half  the  value  of 
the  property  in  use  as  an  organized  enterprise."  2 

The  present  misunderstanding  of  this  question  is  fur- 
ther increased  by  the  attempts  made  by  appraisers  them- 
selves to  find  the  present  value  of  the  property;  in  other 
words,  to  usurp  the  functions  of  the  court  or  commis- 
sion. Experts  are  to  present  to  the  court  or  commission 
certain  figures,  which  were  recapitulated  in  Chapter  I, 
and  that  tribunal  and  that  tribunal  alone  is  to  determine 
"with  sound  and  well  informed  judgment/'  the  true 
present  value,  and,  in  the  true  present  value,  they  have 
ruled  that  they  will  include  what  seems  to  them  to  be  the 
value  inherent  in  the  plant  as  a  live  plant  furnishing 
service  and  earning  money.  They  will  not  attempt  to 
attribute  values  to  definite  factors  analytically  deter- 
mined but  to  the  operating  plant  as  a  whole,  to  the  plant 
as  a  going  concern. 

For  the  sake  of  clearness  in  presentation  we  have  spoken 
of  " going  value"  as  one  of  the  factors  tending  to  give 
life  to  the  plant  and  have  shown  how  this  factor  is  in 

1  Kennebec  Water  District  v.  City  of  Waterville,  54  Atl.  20,  (1902). 

2  Chicago  and  Northwestern  Railway  Co.  v.  The  State  (1906)  128  Wise. 
617. 


VALUE  AS  GOING  CONCERN  91 

reality  the  cost  of  producing  or  reproducing  the  business 
as  distinguished  from  the  plant.  This  "going  value " 
is  but  one  element  of  the  value  inherent  in  the  plant, 
of  its  value  "as  a  going  concern."  As  just  defined  the 
"going  value"  is  capable  of  definite  determination  by  the 
expert  and  must  be  made  by  him  a  figure  to  be  presented 
both  with  the  original  cost  and  with  the  replacement 
cost.  The  "value  as  a  going  concern"  or,  as  it  has  been 
termed  throughout  the  present  study,  "the  value  of  the 
live  plant,"  in  order  to  avoid  the  ambiguity  liable  to  arise 
from  the  use  of  such  similar  expressions,  "going  value" 
and  "value  as  a  going  concern,"  is  to  be  determined  by 
the  Court  upon  well  informed  judgment  based  upon  the 
varied  sets  of  figures  presented  by  the  appraisers. 

65.  Practical  usefulness  of  methods  of  determining 
value  in  live  plant.  —  In  the  first  portion  of  the  present 
chapter  a  number  of  methods  were  described  which  have 
been  used  in  important  appraisals.  It  is  to  be  noted  that 
they  varied  widely  from  each  other  and  would  have  pro- 
duced divergent  figures.  It  is  of  interest  to  note  that, 
while  each  method  has  had  its  advocates,  still  each  method 
has  been  held  by  other  experts,  and  in  some  instances  by 
the  courts,  to  be  unreliable.  It  now  remains  to  be  shown 
that  each  method  is  productive  of  figures  which  have  their 
own  logical  and  proper  value  as  evidence  when  taken  in 
connection  with  the  figures  which  Mr.  Justice  Harlan 
has  ruled  are  essential  for  the  information  of  the  court 
in  making  a  decision  as  to  the  true  present  value  of  a 
property. 

Original  cost  was  one  of  the  figures  to  be  presented  by 
the  experts.  This  figure  should  not  be  the  original  cost 
of  the  plant  alone  but  the  cost  of  the  plant  plus  what  it 
had  cost  the  undertaking  to  acquire  its  business.  This 
latter  cost,  carefully  determined  and  from  which  all 
improper  expenses  have  been  excluded,  is  as  much  a 


92  PUBLIC  UTILITIES 

part  of  the  original  cost  of  the  property  as  the  original 
cost  of  the  physical  plant  itself.  This  cost,  the  capitali- 
zation of  losses,  as  determined  by  the  method  employed 
by  the  Wisconsin  Commission,  when  added  to  the  original 
cost  of  the  plant  is  one  figure  to  be  presented.  It  is  not 
the  true  value  inherent  in  the  live  plant  any  more  than 
the  replacement  cost  is  the  true  value  of  the  physical  prop- 
erty. It  is  simply  evidence,  presented  to  the  tribunal 
for  what  that  tribunal  may  consider  it  to  be  worth. 

Another  figure  to  be  presented  is  the  present  cost  of 
reproducing  the  property.  The  cost  of  a  new  plant  would 
be  the  replacement  cost  of  the  existing  plant.  But  the 
replacement  cost  of  the  physical  plant  represents  in  most 
cases  but  a  portion  of  the  reproduction  cost  of  the  prop- 
erty. It  would  take  time  and  money  to  bring  a  new 
plant  into  the  productive  condition  of  the  existing  prop- 
erty. The  cost  of  reproducing  the  business  must  be  added 
to  the  replacement  cost  of  the  plant  to  give  the  reproduc- 
tion cost  of  the  property.  This  cost  of  reproducing  the 
business  must  be  determined  by  the  method  described 
above  under  the  heading  "  Reproduction  of  Net  Earn- 
ings." The  reproduction  cost  of  the  property,  as  thus 
formed,  does  not  show  the  true  present  value  nor  is  the 
figure,  designed  to  show  the  cost  of  reproducing  the  net 
earnings,  a  criterion  or  even  a  measure  of  the  value  inher- 
ent in  the  live  plant.  These  three  figures,  replacement 
cost,  reproduction  of  net  earnings  and  their  sum  are  simply 
further  evidences  for  the  use  of  the  court  or  commission  in 
forming  its  judgment  as  to  the  fair  present  value  of  the 
property. 

Another  figure  to  be  presented  is  the  commercial  value 
as  shown  by  the  capitalization  of  net  earnings.  This  is 
the  figure  which  appeals  most  to  the  business  man  and  is 
offered  with  the  others,  as  evidence  of  value,  for  the 
consideration  of  the  court.  Thus,  — 


VALUE  AS  GOING  CONCERN  93 

"  Capitalization  of  income,  even  at  reasonable  rates,  cannot 
be  adopted  as  a  sufficient  or  satisfactory  test  of  present  value. 
But  while  not  a  test,  present  and  probable  future  earnings  at 
reasonable  rates  are  properly  to  be  considered  in  determining 
the  present  value  of  the  system." 

Another  figure  to  be  presented  is  the  par  value  of  stocks 
and  bonds.  Some  of  these  securities  may  not  be  repre- 
sentative of  a  dollar  actually  paid  into  the  capital  of  the 
undertaking.  Some  of  them  may  be  common  stock 
issued  to  assure  the  sale  of  other  securities.  It  matters 
not  why  or  how  the  securities  were  issued.  The  court 
or  commission  must  have  these  figures  to  add  to  its  infor- 
mation concerning  the  case. 

Another  figure  is  the  worth  of  the  service  to  the  user. 
As  will  be  shown  later,  the  value  of  the  service  to  the  com- 
munity is  based  largely  upon  what  it  would  cost  the 
public  to  construct  a  new  plant  and  acquire  the  business 
of  the  original  undertaking.  The  cost  of  reproducing 
the  plant  and  business  is  the  reproduction  cost  of  the 
property  described  above.  In  addition  to  this  the  pub- 
lic has  been  relieved  by  the  undertaking  from  the  risk 
originally  incident  to  the  development  of  the  enterprise. 
Some  additional  value  should  be  given  to  the  property 
for  this  reason  and  the  method  termed  above  "  Capital- 
ization of  Profits"  offers  the  means  of  determining  what 
this  increment  may  be.  This  figure  is  presented  with 
the  others  for  the  consideration  of  the  court,  as  evi- 
dence of  the  true  present  value  of  the  property. 


CHAPTER  V 

VALUES   OF   GOOD   WILL  AND   FRANCHISES 

66.  Good  will  and  franchise  values  attributes  of  value  inherent  in  live 

plant. 

67.  Goodwill. 

68.  Franchise  —  General  consideration. 

69.  Value  of  franchise  in  case  of  sale. 

70.  Value  of  franchise  in  cases  involving  the  equity  of  a  statutory  rate. 

71.  Value  of  franchise  in  valuations  for  taxation. 

66.  Good  will  and  franchise  values  attributes  of  value 
inherent  in  live  plant.  —  In  the  last  chapter  it  was  ex- 
plained that,  while  there  was  admittedly  a  value  in  many 
operating  undertakings  over  and  above  the  value  of  the 
physical  plant  alone,  difficulties  were  met  when  an  attempt 
was  made  to  consider  such  value  analytically  and  assign 
values  to  supposed  constituent  attributes.  The  full  sig- 
nificance of  this  was  seen  from  the  fact  that  doubt  was 
expressed  whether  even  value  as  a  "going  concern/ ' 
the  most  unquestioned  attribute  of  a  live  property,  - 
could  be  included  in  a  valuation  made  for  the  purpose  of 
determining  the  equity  of  a  statutory  rate.  As  will  be 
shown  presently,  this  possible  value  has  been  reduced 
still  further  by  the  definite  exclusion  of  the  values  possibly 
attributable  to  good  will  and  franchise  rights. 

In  view  of  the  impossibility  of  experts  assigning  definite 
figures  to  values  inherent  in  a  live  plant,  it  is  not  neces- 
sary to  enter  into  an  extended  discussion  as  to  the  reasons 
why  the  factors,  good  will  and  franchises,  considered 
alone,  have  been  excluded  as  incapable  of  being  assigned 
definite  values.  A  few  only  of  the  rulings  bearing  upon 
these  so-called  intangible  assets  will  be  presented. 


VALUES  OF  GOOD  WILL  AND  FRANCHISES  95 

67.  Good  will.  —  Good  will  may  be  defined  as  "the 
advantage  or  benefit  which  is  acquired  by  an  establishment 
beyond  the  mere  value  of  the  capital  stock,  funds  or 
property  employed  therein,  in  consequence  of  the  general 
public  patronage,  and  encouragement  which  it  receives 
from  constant  or  habitual  customers,  on  account  of  its 
local  position  or  common  celebrity  or  reputation  for 
skill,  affluence,  punctuality,  or  from  other  existing  cir- 
cumstances or  necessities,  or  even  from  ancient  partial- 
ities or  prejudices."  It  will  be  seen  from  this  definition 
that  good  will  implies  the  exercise  of  choice  on  the  part 
of  the  customer  as  to  which  of  several  establishments 
offers  the  best  inducements  for  his  patronage.  It  would 
seem,  therefore,  as  if  while  there  might  be  "an  element  of 
good  will  in  the  business  of  a  public  service  corporation 
where  competition  exists,  and  the  public  may  resort  to 
more  than  one  public  utility  for  the  desired  service,  yet 
when  the  public  is  confined  to  a  single  public  utility  for 
the  service  the  latter  undertakes  there  would  seem  to  be 
no  ground  upon  which  good  will  could  be  predicated." 

The  above  quotations  seem  to  have  been  taken  as  a  basis 
for  the  decisions  which  have  been  given  in  most  cases  in- 
volving valuations  of  the  properties  of  public  utility 
undertakings.  No  case  has  been  found  where  courts  or 
public  service  commissions  in  this  country  have  allowed 
any  increase  in  the  value  of  the  property  of  such  an  enter- 
prise for  good  will  per  se. 

In  the  case  of  Consolidated  Gas  Company  v.  City  of 
New  York,1  the  lower  court  disallowed  the  item  of  "good 
will"  and  was  sustained  by  the  Supreme  Court.  It 
ruled  that  "good  will"  can  have  no  existence  as  apart 
from  or  detached  from  the  franchise  conferring  the  nec- 
essary privilege.  Such  "good  will "  is  not  capable  of  being 
capitalized. 

1  Consolidated  Gas  Company  v.  City  of  New  York,  157  Fed.  849. 


96  PUBLIC  UTILITIES 

In  the  Cleveland  Railway  arbitration,  Judge  Taylor  said : 

"Nor  do  I  find  anything  properly  allowable  for  good  will,  as 
that  term  is  generally  defined.  A  street  railway  company 
which  has  a  monopoly,  and  especially  if  it  has  a  franchise  value 
remaining,  can  have  no  good  will  value." 

Both  of  the  above  decisions  indicate  the  futility  of  an 
analytical  determination  of  the  value  inherent  in  a  live 
plant.  Mr.  Justice  Lurton  said: 

"That  kind  of  good  will,  as  suggested  in  Willcox  v.  Consol- 
idated Gas  Co.,  (212  U.  S.  19),  is  of  little  or  no  commercial 
value  when  the  business  is,  as  here,  a  natural  monopoly,  with 
which  the  customer  must  deal,  whether  he  will  or  no."  1 

Judge  -Savage  said : 

"But  the  term  'good  will'  may  be  misleading.  Lord  Eldon 
said  that  good  will  is  nothing  more  than  the  probability  that 
the  old  customers  will  resort  to  the  old  place.  Crutwrell  v.  Lye, 
17  Ves.  Jr.  335.  ...  See  Flagg  Mfg.  Co.  v.  Holway,  178  Mass. 
83.  Under  any  possible  definition,  it  involves  an  element  of 
personal  choice.  This  phrase  is  inappropriate  where  there 
can  be  no  choice.  So  far  as  the  defendants'  system  is  'prac- 
tically exclusive/  the  element  of  good  will  should  not  be  con- 
sidered. Bristol  v.  Bristol  and  Warren  Water  Works,  34  Atl. 
359."  2 

It  is  to  be  noted  that,  in  all  of  the  above  decisions,  the 
idea  of  good  will  arises  from  the  preference,  in  trade  rela- 
tions, which  is  possessed  by  a  long  established  and  success- 
ful private  competitive  business.  With  a  public  utility, 
good  will,  if  it  exists  at  all,  has  a  value  which  "  shades  into  " 
franchise  value  in  such  a  way  that  it  cannot  be  recognized 
in  a  valuation  as  a  definite  attribute  of  the  property. 

68.  Franchise.  General  consideration.  —  The  fun- 
damental difficulty  in  assigning  a  value  to  the  franchise 
of  a  public  utility  lies  in  the  fact  that  the  undertaking, 

1  City  of  Omaha  v.  Omaha  Water  Co.,  218  U.  S.  180. 

2  Kennebec  Water  District  v.  City  of  Waterville,  54  Atl.  19. 


VALUES  OF  GOOD  WILL  AND  FRANCHISES  97 

in  accepting  the  franchise  and  devoting  its  property  to 
public  use,  must  submit  to  the  right  of  the  public  to  reg- 
ulate its  compensation  for  such  use.  Thus,  except  when 
a  special  term  of  years  is  specified,  the  franchise  can  be 
kept,  changed  or  recalled,  at  the  pleasure  of  the  State  or 
of  such  bodies  as  may  represent  the  State.  The  under- 
taking must  submit  to  such  regulation,  unless  it  can 
satisfy  the  Courts  that  the  action  of  the  State  is  confisca- 
tory  of  its  property  and,  in  consequence,  in  violation  of 
the  laws  of  the  United  States. 

The  value  of  a  franchise,  generally  speaking,  must  be 
based  on  the  capacity  of  the  undertaking  to  earn  a  profit. 
"If  its  earning  power  be  reduced  by  regulation,  the  value 
of  the  property  is  pro  tanto  reduced,  and,  since  the  franchise 
is  property,  the  value  of  the  franchise  is  also  reduced.."  l 

The  value  of  the  franchise  will  be  different  depending 
upon  the  purpose  for  which  the  appraisal  is  made. 

69.  Value  of  franchise  in  case  of  sale.  —  If  a  property 
is  earning  a  profit  and  is  taken  from  its  owners  by 
condemnation,  then  the  franchise  must  be  paid  for,  and 
consequently  has  a  definite  value.  "When  property  used 
under  a  franchise  is  condemned,  the  whole  property  is 
taken.  The  franchise  is  paid  for  as  well  as  the  physical 
property.  The  idea  that  a  valuable  franchise  could  be 
taken  in  condemnation  proceedings,  without  compensa- 
tion, would  not  be  tolerated  for  an  instant;  and  to  per- 
mit such  a  franchise  to  be  taken  without  consideration, 
indirectly,  by  means  of  rate  regulation,  is  equally  obnox- 
ious to  the  federal  Constitution."  2 

That  franchises  of  this  nature  are  property  and  cannot 
be  taken  or  used  by  others  without  compensation  has 
been  fully  established  by  the  Supreme  Court. 3 

1  Consolidated  Gas  Co.  v.  City  of  New  York  (1907)  157  Fed.  876. 

2  Spring  Valley  Water  Co.  v.  City  and  County  of  San  Francisco  (1908) 
165  Fed.  693. 

3  See  Monongaheja  Navigation  Co.  v.  United  States  (1893)  148 U.S.  312. 


98  PUBLIC  UTILITIES 

From  these  general  statements  it  will  be  seen  that  for 
a  case  of  condemnation  or  sale,  "the  value  of  the  prop- 
erty, generally  speaking,  is  determined  by  its  productive- 
ness,—  the  profits  which  its  use  brings  the  owners," 
and  that  such  productiveness  cannot  be  reduced  prior 
to  a  sale  by  means  of  rate  regulation.  These  facts  do 
not  alter  in  any  way  the  nature  of  the  appraisal  nor  the 
figures  that  must  be  prepared  by  the  experts  and  pre- 
sented to  the  court.  It  means  simply  that,  in  finding 
the  true  present  value  of  the  property,  the  value  of  the 
physical  property  and  the  capitalized  net  earnings  become 
figures  of  special  importance  to  the  Court  in  forming  his 
judgment  as  to  what  that  value  should  be  decided  by  him 
to  be. 

70.  Value  of  franchise  in  cases  involving  the  equity 
of  a  statutory  rate.  —  The  difficulty  which  arises  in  cases 
of  this  character  lies  in  the  fact  that,  as 

"The  value  of  the  franchise  is  itself  based  on  the  capacity 
of  the  company  to  earn  profits;  and  it  becomes  greater  when 
the  earnings  of  the  company  are  increased.  If,  therefore,  a 
high  rate  of  income  could  be  justified  on  account  of  the  great 
value  of  the  franchise,  this  fact  would  in  turn  enhance  the 
value  of  the  franchise  itself  and  so  justify  a  still  higher  charge; 
and  there  would  be  no  limit  to  the  legal  charge  of  the  company 
which  could  be  enforced  should  such  franchise  value  be  per- 
mitted to  increase  in  this  way  the  capital  charges."  1 

The  above  reasons  and  the  fact  that  the  rates  and, 
consequently,  the  return  upon  the  property  of  the  under- 
taking, are  dependent  upon  regulation,  based  upon  the 
will  of  the  people,  —  that  is  to  say  of  the  State,  —  have 
led  to  the  exclusion  of  franchise  values  per  se  as  elements 
of  value  in  the  property  of  a  public  utility  corporation, 
except  for  such  cases  as  definite  payments  have  been 
made  for  the  franchise  or  that  some  special  condition  is 

1  Wyman  on  Public  Service  Corporations,  Vol.  II,  §  1104. 


VALUES  OF  GOOD  WILL  AND  FRANCHISES  99 

present  in  a  particular  case  to  work  exception  to  the 
general  rule. 

The  Wisconsin  Commission  has  consistently  held  that 
no  franchise  values  could  be  considered  for  rate  making 
purposes  other  than  those  which  are  represented  by  a 
reasonable  cost  to  the  investor. 

"Franchises  are  not  always  obtained  without  cost.  Many 
of  them  include  provisions  which  entail  outlays  that  may  be 
charged  either  to  the  capital  account  or  the  operating  expenses. 
The  former  may  consist  of  considerations  in  the  form  of  stip- 
ulated payments  to  the  municipality,  license  fees,  a  certain 
amount  of  free  service  upon  which  values  can  be  placed,  and 
other  items  of  this  character.  The  latter  may  include  the 
up-keep  of  streets  and  other  property,  extra  services  of  various 
kinds,  and  other  items  of  a  similar  nature.  The  former,  again, 
would  seem  to  be  as  much  a  part  of  the  investment  in  the  plant 
and  in  its  business  as  the  cost  of  the  physical  plant,  and  there 
would  appear  to  be  the  best  of  reasons  why  such  costs  should 
be  included  in  the  value  of  the  plant  for  rate  making  purposes."  l 

And  again: 

"It  is  difficult,  if  not  impossible,  to  discover  any  justice  in 
the  practice  of  including  in  the  valuation  of  a  plant,  for  rate 
making  purposes,  such  values  of  its  franchise  as  are  based  upon 
surplus  earnings  only,  or  which  have  not  cost  the  plant  any- 
thing."2 

An  exception  to  the  above  practice,  of  not  allowing  a 
value  to  a  franchise  except  when  actual  payment  has 
been  made,  occurred  in  one  recent  case  wherein  a  value 
which  had  been  agreed  to  by  the  stockholders  and  was 
provided  for  in  the  act  which  was  followed  by  the  com- 
panies, had  been  previously  assigned  to  the  franchise  at 
the  time  of  a  consolidation.  The  judge  in  the  lower  court 

"stated  his  own  views  as  opposed  to  including  these  franchises 
in  the  property  upon  the  value  of  which  a  return  is  to  be  cal- 

1  Wis.  R.  R.  Com.  Rpts.,  Vol.  3,  p.  727.  2  Ibid.,  p.  729. 


100  PUBLIC  UTILITIES 

culated  in  fixing  the  amount  of  rates,  but  held  that  he  was 
bound  by  decided  cases  to  hold  against  his  personal  views."  l 
He  said  "private  citizens  may  acquire  vested  property  rights 
through  a  series  of  even  erroneous  decisions;  rights  so  firmly 
vested  that  it  becomes  unconstitutional  for  the  court  which 
persisted  in  error  suddenly  to  rectify  its  mistakes  to  the  detri- 
ment of  those  who  had  securely  rested  upon  the  decisions  sought 
to  be  invalidated."  2 

In  the  decision  of  this  case  by  the  Supreme  Court  the 
value  allowed  originally  by  act  of  the  State  was  included 
but  no  increase  in  value  was  permitted.  The  Supreme 
Court  said:  — 

"What  has  been  said  herein  regarding  the  value  of  the 
franchises  in  this  case  has  been  necessarily  founded  upon  its  own 
peculiar  facts,  and  the  decision  thereon  can  form  no  precedent 
in  regard  to  the  valuation  of  franchises  generally,  where  the 
facts  are  not  similar  to  those  in  the  case  before  us."  3 

It  is  seen  from  the  above  that,  although  no  value  can 
be  assigned  definitely  by  the  expert  as  a  value  to  be  pre- 
sented in  an  appraisal,  it  does  not  affect  the  figures  to 
be  prepared  by  him  and  presented  to  the  Court.  The 
Court  will  give  only  such  weight  to  the  capitalized  net 
earnings  as  in  his  judgment  may  seem  proper.  The  past 
earnings  of  a  company  may  not  be  evidence  of  the  fair 
value  of  the  property  but  it  is  testimony  which  will  be 
considered  by  the  Court. 

71.  Value  of  franchise  in  valuations  for  taxation.  — 
Valuations  in  cases  of  this  character  are  different  from 
the  above,  as  no  question  is  involved  as  to  the  continu- 
ance of  the  rates.  The  valuation  is  based  simply  upon 
the  present  earning  capacity  of  the  property,  If  there 
is  a  value  in  the  property  over  and  above  the  value  of 
the  physical  plant,  it  has  value  in  what  may  be  called 

1  Willcox  v.  Consolidated  Gas  Co.,  212  U.  S.  45. 

2  Consolidated  Gas  v.  City  of  New  York,  157  Fed.  849. 
8  Willcox  v.  Consolidated  Gas,  212  U.  S.  19  (1909). 


VALUES  OF  GOOD  WILL  AND  FRANCHISES          101 

its  intangible  property,  be  it  good  will,  going  value,  or 
franchise  value.  This  intangible  value  arises  from  the 
rights  given  to  the  company  to  operate  and  may  be  of 
definite  value  due  to  its  fruitfulness  at  the  date  of  the 
investigation.  No  inconsistency  is  introduced  by  the 
fact  that  a  diminution  may  later  arise  as  a  result  of  legis- 
lative action.1 

1  See  Beale  and  Wyman,  Railroad  Rate  Regulation,  Sees.  362-363. 


CHAPTER  VI 

ORIGINAL   COST 

72.  Necessity  of  an  unbiased  determination  of  original  cost. 

73.  Original  cost  required  by  court  decisions. 

74.  Neglect  in  past  of  figures  showing  original  cost. 

75.  Abandoned  or  destroyed  plant  cannot  be  given  value. 

76.  Difficulty  in  obtaining  original  cost. 

77.  Unit  costs. 

78.  Piecemeal  construction. 

79.  Pavement  over  construction. 

80.  Overhead  charges. 

81.  Sale  of  securities. 

82.  Cost  of  developing  business. 

72.  Necessity  of  an  unbiased  determination  of  orig- 
inal cost.  —  As  with  all  other  figures  presented  by  the 
engineer,  the  original  cost  must  be  determined  without 
any  regard  whatever  as  to  the  effect  that  such  a  figure 
may  have  upon  the  fair  present  value. 

It  seems  perfectly  right  to  assume  that  the  tribunals, 
whose  duty  it  is  to  ascertain  the  fair  present  values  of  the 
properties  of  public  utilities,  will  be  just  to  the  present 
holders  of  the  securities  of  such  companies  by  not  penal- 
izing them  for  errors  and  extravagancies  committed  in  the 
past,  possibly  by  former  owners  and  under  different  man- 
agements. It  must  be  recognized  that  it  is  only  within 
a  relatively  short  time  that  the  full  duty  of  public  ser- 
vice corporations  to  the  public  has  been  understood  or 
appreciated  either  by  the  undertakings  or  by  the  public. 
It  seems  reasonable  to  expect  that  the  tribunal,  either 
Court  or  State,  will  give  full  weight  to  the  fact,  if  proved, 
that  the  undertaking  has  property  of  a  present  value, 
based  on  present  prices,  at  least  equal  to  the  capital  upon 


ORIGINAL  COST  103 

which  returns  have  been  paid,  even  though  the  original 
cost  of  that  property,  the  money  contributed  by  the 
stockholders  to  buy  and  construct  that  property,  may" 
have  been  less.  There  is  no  question  of  the  fact  that  very 
many  undertakings  have  issued  stock  to  their  shareholders 
without  payment,  and  that,  as  a  result  of  this  practice, 
the  capital  assets  are  greater  than  the  original  or  actual 
cost  of  their  property.  Such  a  practice  has  been  a  com- 
mon and  usual  plan  of  rewarding  stockholders  for  the 
risks  which  they  have  taken  in  initiating  a  new  enter- 
prise which  has  proved  remunerative.  It  must  be 
recognized  that,  as  far  as  public  utility  undertakings  are 
concerned,  this  method  of  financing  belongs  to  the  past. 

It  seems  right  to  assume  that  the  tribunal  will  recog- 
nize that  a  new  era  in  the  management  of  public  util- 
ities has  begun,  that  the  past  must  be  obliterated  as  far 
as  may  be  possible  without  injury  to  the  public  and  that 
it  is  its  duty  to  establish  as  of  to-day  a  value  upon  which 
returns  in  the  future  can  be  based,  which  will  be  fair 
both  to  the  undertaking  and  to  the  public. 

73.  Original  cost  required  by  court  decisions.  —  The 
rulings  which  have  been  given  by  the  courts  have  de- 
manded figures  showing  original  cost  in  order  that  present 
value  may  be  properly  determined.  Two  decisions  only 
need  be  quoted  to  emphasize  this  demand. 

"So  that  the  right  of  the  public  to  use  the  defendant's  turn- 
pike upon  payment  of  such  tolls  as  in  view  of  the  nature  and 
value  of  the  service  rendered  by  the  company  are  reasonable, 
is  an  element  in  the  general  inquiry  whether  the  rates  estab- 
lished by  law  are  unjust  and  unreasonable.  That  inquiry 
also  involves  other  considerations,  such,  for  instance,  as  the 
reasonable  cost  of  maintaining  the  road  in  good  condition 
for  public  use,  and  the  amount  that  may  have  been  really  and 
necessarily  invested  in  the  enterprise.  In  short,  each  case  must 
depend  upon  its  special  facts."1 

1  Covington  &  Lexington  Turnpike  Co.  v.  Sandford,  164  U.  S.  578,  597. 


104  PUBLIC  UTILITIES 

"The  actual  cost  of  the  plant  and  property,  together  with 
proper  allowance  for  depreciation  ...  is  competent  evidence, 
but  it  is  not  conclusive.  It  is  not  a  controlling  criterion  of  value, 
but  it  is  evidence."  1 

The  original  cost  may  have  been  abnormally  high  or 
abnormally  low,  but  whatever  it  may  have  been,  it  is 
a  figure  of  prime  importance,  in  theory  at  least,  to  the 
tribunal  as  a  guide  to  its  decision  as  to  what  the  fair 
present  value  of  a  property  should  be. 

74.  Neglect  in  past  of  figures  showing  original  cost. 

• —  In  but  few  valuations  have  original  costs  been  pre- 
pared and  presented  to  rate  regulating  tribunals,  prob- 
ably largely  for  the  reason  that  the  original  cost  shows 
in  no  way  the  increased  value  which  has  accrued  to  most 
undertakings  in  this  country  from  increased  values 
principally  of  land  and  of  labor.  The  replacement  cost 
is  designed  to  show  the  cost-new  at  the  present  time  and, 
in  most  cases,  the  value  derived  from  the  replacement 
cost  would  be  considerably  greater  than  could  be  derived 
from  the  original  cost  alone. 

In  consequence  of  this,  —  and  probably  also  of  a  lack 
of  appreciation  of  what  is  meant  by  original  cost, — fig- 
ures showing  this  cost  have  been  omitted  from  most 
valuations,  so  that  there  is  little  or  no  precedent  to  guide 
the  engineer  as  to  what  original  cost  really  is  nor  how,  as 
a  practical  matter,  figures  to  show  it  are  to  be  obtained. 

It  will  be  necessary,  therefore,  to  study  such  decisions 
as  are  available  to  determine  what  the  Court  meant 
when  it  said  that  "the  original  cost  of  construction" 
should  be  ascertained. 

75.  Abandoned  or  destroyed  plant  cannot  be  given 
value.  —  Much  of  the  present  existing  physical  property 

1  Kennebec  Water  District  v.  City  of  Waterville,  54  Atl.  p.  15. 
See  also  Cotting  v.  Kansas  City  Stock  Yard  Co.,  183  U.  S.  79. 
Westchester  Turnpike  v.  Westchester  County,  37  Atl.  905. 
Griffen  v.  Goldsboro  Water  Co.,  122  N.  C.  206. 


ORIGINAL  COST  105 

of  an  undertaking,  which  has  been  in  operation  for  a  num- 
ber of  years,  has  replaced  plant  which  has  been  aban- 
doned or  destroyed  for  the  reason  that  it  was  no  longer 
useful  to  the  public.  There  is  no  question  or  doubt  about 
the  fact  thatfthe  cost  of  such  abandoned  plant  cannot  be 
included  in  ascertaining  the  replacement  cost  of  the  prop- 
erty. It  is  the  plant  as  it  is  that  must  be  valued,  —  the 
plant  then  in  existence  and  useful  to  the  public  at  the  time 
of  the  appraisal.1 

The  question  to  be  settled  relative  to  original  cost  is 
whether  the  cost  of  such  abandoned,  destroyed  or  unser- 
viceable plant  is  to  be  made  a  portion  of  the  original 
cost.  The  best  decision  bearing  upon  this  point  was 
given  in  the  Knoxville  case.  The  defendants  contended 
that  amounts  representing  "  complete  depreciation" 
should  be  added  to  the  present  value  of  the  surviving 
parts  of  the  plant  to  reach  the  sum  upon  which  the  com- 
pany should  be  entitled  to  earn  a  return.  ''Complete 
depreciation"  was  denned  by  the  company  as  that  part 
of  the  original  plant  which  had  entirely  disappeared 
through  destruction  and  obsolescence.  The  Court  ruled, 
"The  court  refused  to  approve  this  method,  and  we 
think  properly  refused."  2 

Again,  in  Switzerland,  in  cases  involving  the  purchase 
of  the  railroads  by  the  Government,  it  was  ruled  that 
property  constructed  and  destroyed  or  abandoned  could 
not  be  given  any  value.3 

The  logic  of  these  rulings  is  apparent  when  it  is  remem- 
bered that  an  undertaking  is  entitled  to  such  rates  as 
will  enable  it  to  make  annual  reserves  from  income  suffi- 
cient in  amount  to  cover  all  losses  occurring  from  the 
replacement  of  old  or  obsolete  units  of  plant.  If  an 

1  Wis.  R.  R.  Com.  Rpts.,  Vol.  5,  p.  397. 

2  Knoxville  v.  Knoxville  Water  Co.,  212JJ..3..1. 

3  U.  S.  Bureau  of  Census  Bulletin  21,  (1905),  p.  72. 


106  PUBLIC  UTILITIES 

undertaking  has  made  such  reserves,  the  cost  of  the  dis- 
carded plant  has  been  paid  for  practically  by  the  public 
in  the  form  of  the  higher  rates  that  such  a  practice  has 
necessitated. 

What  the  Court  requires  is  the  " original  cost"  of  the 
plant  now  found  in  existence.  But  there  is  confusion  as 
to  what  " original  cost"  really  means:  does  it  mean  the 
amount  of  money  that  was  paid  originally  for  the  first 
unit  brought  into  service,  —  a  unit  which,  probably,  has 
been  replaced  many  times  in  the  past;  or  does  it  mean 
the  actual  cost  of  the  unit  now  found  in  service,  —  the 
unit  now  performing  the  same  functions  as  the  original 
unit?  Logically,  there  seems  to  be  but  one  answer  to 
this  question.  The  /'original  cost"  must  be  the  cost  of 
the  unit  now  in  existence.  The  logic  of  this  reasoning 
will  be  apparent  when  practical  cases  are  considered. 
If  a  valuation  of  a  street  railway  was  being  made,  it  would 
be  quite  absurd  to  furnish  the  court  with  the  original 
costs  of  the  cars  drawn  by  horses,  cars  which  had  been 
replaced  by  cable  cars  and  later  by  the  electric  cars  now 
found  in  a  portion  of  the  property  being  valued.  Or  if 
a  telephone,  telegraph  or  electric  light  company  was 
being  appraised,  there  would  be  no  assistance  afforded 
the  tribunal  by  presenting  to  it  the  prices  paid  for  a  pole 
at  the  time  the  plant  was  first  constructed.  Such  a 
figure  could  furnish  no  indication  of  the  value  of  a  pres- 
ent pole,  which  possibly  is  the  fourth  pole  that  has  been 
placed  by  the  undertaking  in  that  spot,  each  pole  having 
replaced  one  that  had  had  to  be  abandoned  owing  to 
its  lack  of  physical  strength  arising  from  its  years  of 
service. 

It  would  seem,  therefore,  as  if  the  .original  cost  must 
mean  actual  cost,  that  is  to  say  the  price  actually  paid 
for  the  identical  unit  now  found  in  the  plant  in  use  and 
useful  to  the  service  offered  to  the  public. 


ORIGINAL  COST  107 

76.  Difficulty  in  obtaining  original  cost.  —  The  reason 
given  for  the  absence  of  original  costs  in  most  valuations 
is  the  difficulty  in  ascertaining  what  the  costs  actually- 
had  been  in  the  past.  It  is  a  very  serious  question 
whether  this  difficulty  has  not  arisen  from  attempts  to 
find  the  first  cost  of  the  original  units.  It  is  a  fact  that, 
for  most  electrical  enterprises  using  units  of  plant  of  rel- 
atively low  mean  life,  there  should  be  no  greater  diffi- 
culty in  finding  the  actual  cost  within  as  great  a  degree 
of  accuracy  as  the  replacement  cost  can  be  obtained. 
There  can  be  no  doubt  that,  if  the  officers  or  accountants 
of  an  undertaking  were  approached  and  asked  for  the 
actual  cost  of  their  plant,  it  would  be  impossible,  in  the 
case  of  older  undertakings,  for  them  to  give  it  with  such 
accuracy  as  they  would  desire.  But,  if  an  inventory, 
the  same  or  similar  in  every  way  to  that  required  and 
used  in  determining  the  replacement  cost,  was  in  hand 
with  the  probable  age  attributable  to  each  unit, — a 
requirement  for  the  determination  of  depreciation  as  will 
be  described  later,  —  most  or  all  of  the  accountant's 
difficulties  would  be  removed. 

The  difficulty  in  obtaining  actual  cost  has  been  stated 
at  some  length  in  the  following  decision: 

"the  court  .  .  .  directed  an  inquiry  into  the  actual  cost  of 
the  company's  property  in  this  city.  The  lapse  of  many  years, 
the  multitude  of  items  making  up  the  total,  the  wide  diversity 
of  present  views  as  to  what  expenditures  should  have  been  or 
should  now  be  included  in  the  cost  of  construction,  etc.,  the 
manner  of  keeping  the  company's  accounts  (though  no  dis- 
honesty is  attributable,  inasmuch  as  no  motive  is  conceivable 
which  at  that  time  tempted  to  deliberate  wrong),  and  other 
considerations  have  so  obscured  the  question  of  cost  of  the  plant 
as  to  greatly  weaken  the  value  of  this  inquiry,  laborious  and 
painstaking  as  it  appears  to  have  been."  L 

1  Cumberland  Telephone  and  Telegraph  Co.  v.  City  of  Louisville,  187 
Fed.  637  (1911). 


108  PUBLIC  UTILITIES 

This  decision  shows  the  error  which,  evidently,  has 
been  made  by  those  attempting  to  obtain  the  actual 
cost.  The  actual  cost  need  not  accord  with  the  books  of 
the  undertaking  as  far  as  classification  is  concerned;  in 
fact  it  is  probable  that  it  could  accord  in  but  few  cases 
and  then  only  of  properties  that  had  been  in  existence  for 
a  short  tune  only.  The  cost  of  some  of  the  present  plant 
may  have  been  charged  to  replacements  or  current  repair 
and  not  entered  directly  as  a  portion  of  the  plant  cost. 

By  far  the  larger  part  of  these  difficulties  is  removed 
if  the  original  cost  is  determined  in  substantially  the 
same  manner  as  was  the  replacement  cost.  An  inven- 
tory is  prepared  showing  all  plant  units  now  in  useful 
service.  Such  an  inventory  is  identical  with  that  required 
for  ascertaining  replacement  cost.  The  age  of  each 
unit  is  ascertained  and  entered  in  the  inventory.  As  will 
be  explained  later,  this  figure  for  age  is  necessary  for  a 
determination  of  the  loss  in  value  of  the  investment  aris- 
ing from  depreciation.  From  this  age  figure  it  is  possible 
to  find  how  many  units  of  each  class  of  elements  were 
constructed  in  each  year  in  the  past.  The  engineer  and 
an  accountant  familiar  with  the  company's  records  can 
ascertain  the  unit  costs  of  all  elements  for  each  year  in 
the  past.  The  sum  of  the  products  of  the  numbers  of 
units  constructed  each  year  by  the  unit  costs  for  that  year 
will  give  the  original  cost.  Overhead  charges  can  be 
found  for  each  year  and  applied  to  the  cost  of  construc- 
tion each  year  in  a  manner  similar  in  all  respects  to  that 
described  under  replacement  cost.  Thus  it  is  seen  that 
the  method  of  determining  original  cost  is  practically  the 
same  as  replacement  cost  except  that  in  the  case  of  the 
original  cost  there  are  several  unit  costs,  one  for  each 
year  in  the  past,  for  each  element,  whereas  for  replace- 
ment cost  there  is  but  one  unit  cost  applicable  to  all 
units  of  the  same  kind. 


ORIGINAL  COST  109 

There  can  be  no  wider  " diversity  of  present  views" 
relative  to  original  costs  than  to  replacement  costs  if  the 
above  reasoning  is  correct.  It  is  not  at  all  improbable 
that  some  of  the  costs  which  should  have  been  made 
properly  a  portion  of  original  costs,  —  some  of  the  over- 
head charges  most  frequently,  —  may  have  been  included 
on  the  books  of  the  undertaking  as  a  portion  of  the  oper- 
ating expenses,  but  a  determination  of  original  cost  is 
not  an  investigation  of  the  capital  cost  as  shown  by  the 
company's  books  but  rather  what  has  been  actually 
spent  in  the  construction  of  the  property  now  in  use  for 
the  convenience  of  the  public. 

77.  Unit  costs.  —  The  unit  costs  developed  for  use  in 
ascertaining  replacement  costs  were  obtained  by  taking 
the  prices  for  labor  and  material  which  had  prevailed  in 
the  past  during  a  period  of  time  assumed  as  that  which 
would  be  required  to  reconstruct  the  property.     For  use 
in  obtaining  actual  cost,  unit  prices  must  be  obtained  in 
which  are  included  all   of   the  items  of   cost  noted  in 
section  32,  for  each  year  in  the  past  in  which  the  units 
now  in  existence  were  installed.     Clearly  this  period  will 
depend  upon  the  life  of  each  element.     The  number  of 
units  of  each  element,  introduced  into  the  plant  during 
each  year,  must  be  multiplied  by  the  unit  costs  determined 
for  that  year. 

78.  Piecemeal   construction.  —  The  first    point   rela- 
tive to  piecemeal  construction,  the  point  discussed  in 
section  26,  cannot  be  questioned  in  any  way  whatever 
in  a  determination  of  the  original  cost.     The  original 
cost  must  be  the  actual  cost  to  the  undertaking  of  the 
work  as  it  was  actually  done  by  it. 

The  second  point,  discussed  in  section  27,  requires  very 
careful  consideration,  particularly  for  the  reason  that  no 
decisions  have  been  found  bearing  upon  this  question 
nor  is  there  any  precedent  to  establish  an  authority  or 


110  PUBLIC  UTILITIES 

guide.  This  point  is  whether  the  greater  cost  naturally 
incident  to  a  plant,  built  at  first  smaller  than  that  now 
found  in  existence  and  later  enlarged,  should  be  taken  as 
the  actual  original  cost;  or  whether  the  reasoning  em- 
ployed in  section  27  relative  to  replacement  cost,  i.e., 
that  the  increased  cost  must  be  due  to  work  or  material 
that  has  been  abandoned,  should  hold  good  when  applied 
to  original  cost. 

There  can  be  no  doubt  whatever  that,  if  a  unit  had 
been  too  small  and  had  to  be  completely  removed  and  a 
new  and  larger  one  substituted,  the  cost  of  the  original 
smaller  unit  of  plant  could  not  be  made  a  portion  of  the 
original  cost.  But  taking  as  an  example  of  a  more 
doubtful  nature  the  case  of  an  underground  conduit 
originally  composed  of,  say,  ten  ducts,  which  had  been 
increased  at  some  later  time  by  ten  more  ducts:  to  place 
the  second  group  of  ducts,  the  pavement  would  have  to 
be  reopened,  the  trench  redug  and  refilled  and  the  street 
repaved.  If  the  conduit  had  been  constructed  originally 
with  twenty  ducts,  the  cost  of  paving,  excavating  and 
filling  would  not  have  been  much  greater  than  it  was  for 
ten  ducts. 

There  is  but  little  doubt  that  most  undertakings  have 
charged  the  cost  of  each  group  of  ducts,  when  laid,  to 
plant  cost  and,  naturally,  they  would  desire  to  have  the 
original  cost  figured  as  the  sum  of  the  two  operations. 
The  undertaking  can  argue  with  perfect  justice  that  it 
had  been  wise  in  thus  constructing  in  a  piecemeal  manner 
and  that  it  might  have  placed  the  second  line  of  ducts 
possibly  equally  well  somewhat  away  from  the  first  for 
substantially  the  same  cost  and  have  had  recognition 
made  in  the  valuation  of  their  proper  and  legitimate 
expense.  This  line  of  argument  is  based  on  very  prac- 
tical considerations  and  any  objection  to  it  must  be 
largely  of  a  theoretical  character.  But  the  fact  remains 


ORIGINAL  COST  111 

that  there  is  at  the  time  of  valuation  a  twenty  duct  con- 
duit and  that  to  place  the  second  section  of  ducts  the  pave- 
ment placed  over  the  first  section  of  ducts  was  destroyed: 
and  abandoned  and  the  same  is  true  of  the  labor  entailed 
in  the  first  excavation.  It  was  the  right  and  duty  of  the 
undertaking  to  charge  off  from  its  construction  account 
the  cost  of  the  labor  and  material  thus  abandoned.  There 
seems  to  be  no  more  reason  for  including  the  cost  of 
abandoned  work  in  the  original  cost  than  there  was  reason 
for  including  it  in  replacement  cost. 

79.  Pavement  over  construction.  —  This  question  has 
been  conspicuous  in  most  appraisals  of  public  service 
undertakings  where  there  is  property  in  large  cities,  and 
in  most  decisions  the  actual  cost  to  the  undertaking  has 
been  the  figure  which  has  been  required  by  the  court  or 
commission  for  its  consideration.  It  is  probably  one  of 
the  most  difficult  portions  of  original  cost  to  be  found 
with  the  desired  accuracy  but  its  importance  demands 
special  effort. 

It  is  true  that  the  undertaking  may  have  laid  its  under- 
ground system  originally  in  unpaved  streets  somewhat 
before  it  was  needed  in  order  to  avoid  the  cost  of  the 
high  grade  pavement  to  be  laid  somewhat  later  by  the 
city;  or,  what  amounts  to  the  same  thing,  that  the  city 
had  obliged  the  undertaking  to  lay  its  underground  pipes 
much  before  they  were  required  in  order  that  a  new  high 
grade  pavement  might  not  be  broken  into  later  when  the 
pipes  were  actually  required  for  the  service  of  the  public. 
There  can  be  no  doubt  that  the  undertaking  was  involved 
in  some  expense  for  interest  and  maintenance  upon  a 
plant  somewhat  larger  than  the  actual  requirements  of 
the  service  at  that  time,  but  such  expense  cannot  be 
made  properly  a  portion  of  the  plant  cost.  Such  expense 
is  a  portion  of  the  annual  cost  of  operation  and  should  not 
be  capitalized.  The  public  pays  a  fair  return  upon  the 


112  PUBLIC  UTILITIES 

plant  in  use  and  useful  to  it.  Plant,  wisely  prematurely 
built  or  placed  on  the  demand  of  the  public  authorities, 
must  be  considered  as  virtually  useful  to  the  public. 
The  courts  have  held  invariably  that  the  public  service 
corporation  "is  under  obligation  to  the  public  to  keep  in 
advance  of  the  present  demand  and  take  liberal  account 
of  the  probable  increase  of  demand  due  to  increase  of 
population. " 

80.  Overhead  charges.  —  The  overhead  charges,  ruled 
as  proper  in  a  determination  of  replacement  cost,  —  viz., 
interest  during  construction,  engineering,  organization  and 
legal  expenses,  —  are  to  be  determined  from  the  books 
of  the  company  and  made  a  portion  of  the  original  cost, 
following  the  general  principles  enunciated  when  the  sub- 
jects were  discussed  as  a  portion  of  replacement   cost. 
It  is  not  at  all  improbable  that  some  of  the  overhead 
charges  will  be  different  for  different  years,  depending 
upon   the  amount  of   construction  work  of  each  year. 
Figures  representative  of  overhead  costs,  however,  can 
be  obtained  in  every  case  without  inordinate  difficulty, 
provided  the  engineer  and  accountant  have  a  definite 
knowledge  and  appreciation  of  the  expenses  which  should 
be  made  a  part  of  these  charges. 

The  item  of  contingencies  should  be  given  special 
consideration  in  each  particular  case.  If  the  books  and 
records  are  in  such  form  that  the  actual  costs  can  be 
determined  and  the  inventory  of  the  plant  and  the  ages 
of  the  units  have  been  prepared  with  proper  care  and 
skill,  it  is  difficult  to  see  good  reason  for  making  this 
item  one  of  any  importance. 

81.  Sale    of    securities.  —  In    the    discussion    of    the 
replacement  cost  of  a  plant,  it  was  stated  that  "the 
discounts  or  losses  which  an  undertaking  might  incur  in 
order  to  sell  its  stocks  or  bonds,   together  with  such 
expenses  as  may  be  incurred  by  underwriting  an  issue  of 


ORIGINAL  COST  113 

the  securities"  should  not  be  made  a  portion  of  the  replace- 
ment cost  of  a  plant.  It  has  been  contended,  however, 
that  no  new  undertaking  can  obtain  money  for  the  con^ 
struction  of  a  plant  and  the  development  of  a  new  busi- 
ness without  some  expense  and  that  such  expense  should 
be  included  as  a  legitimate  portion  of  the  original  cost  of 
its  property.  It  has  been  argued,  further,  that,  if  the  money 
required  for  the  construction  and  operation  of  the  plant 
had  been  obtained  as  cheaply  and  economically  as  possible, 
and  if  all  the  money  thus  obtained  had  been  used  in  the 
construction  of  the  plant  and  in  its  operation  during  the 
development  period  of  the  business,  the  cost  of  obtaining 
funds,  —  the  discounts  between  par  value  and  the  price 
obtained,  —  was  properly  a  portion  of  the  original  cost. 

Here  again  the  instructions  of  Mr.  Justice  Harlan  must 
be  recalled.  He  ruled  that  the  original  cost  of  the  prop- 
erty should  be  found  and  presented  to  the  Court  as  well 
as  figures  showing  the  amount  of  the  bonds  and  stocks  of 
the  undertaking.  The  Court  has,  thus,  before  it  informa- 
tion which  will  show  by  how  much  the  capitalization  ex- 
ceeds the  original  cost.  Any  attempt  on  the  part  of  the 
engineer  or  expert  to  add,  to  the  original  cost  of  the  prop- 
erty, figures  representing  what  in  his  opinion  the  cost  of 
obtaining  money  originally  may  have  been  and  including 
such  cost  in  the  original  cost  of  the  property  is  unneces- 
sary and  an  assumption  of  the  functions  of  the  Court. 

Thus  the  economic  arguments  which  have  been  made 
so  often,  that  the  management  of  the  undertaking  showed 
good  business  judgment  in  the  sale  of  securities  at  a 
larger  discount  at  a  low  rate  of  interest  rather  than 
at  a  higher  price  at  a  higher  rate,  need  no  special  pres- 
entation on  the  part  of  the  appraiser.  The  facts  are 
presented  to  the  Court  in  the  statement  prepared  by 
the  appraiser  showing  the  character  of  the  securities  and 
the  rate  of  interest  which  they  bear. 


114  PUBLIC  UTILITIES 

Moreover  the  interest  during  the  construction  period 
is  based  upon  the  rate  of  interest  the  undertaking  had 
to  pay  for  the  money  required  in  the  construction  of  the 
plant  and  this  rate  should  be  made  to  cover  the  losses 
practically  applicable  to  that  period. 

82.  Cost  of  developing  business.  —  The  cost  of  the 
physical  property  is  but  a  portion  of  the  original  cost  of 
the  entire  property,  as  has  been  fully  explained  in  the 
chapter  dealing  with  "the  value  inherent  in  a  live  plant." 
The  original  cost  of  developing  the  business  must  be 
determined  and  added  to  the  original  cost  of  the  physical 
plant  in  order  that  a  complete  comparison  can  be  made 
between  the  original  cost  of  the  property  and  its  replace- 
ment cost  at  the  present  time.  The  original  cost  of  devel- 
oping the  business  should  be  determined  by  the  method 
employed  by  the  Wisconsin  Commission  and  briefly 
described  in  section  61.  In  ascertaining  this  cost,  care 
should  be  taken  to  see  that  only  such  figures  are  included 
as  can  be  considered  reasonable  and  proper  expenses  in 
the  conduct  and  development  of  a  utility  of  the  kind  under 
appraisal.  It  must  be  appreciated  by  those  whose  duty 
it  is  to  determine  this  cost  that  the  results  of  their  work 
will  be  scrutinized  by  the  tribunal  to  ascertain  whether 
the  character  of  the  plant  was  suited  to  the  needs  of  the 
community,  whether  its  cost  as  related  to  similar  plants 
elsewhere  was  too  high,  whether  the  operating  expenses 
in  the  past  had  been  usual  and  reasonable,  and  whether 
undue  charges,  in  the  way  of  salaries  or  as  cost  of  replace- 
ment of  faulty  construction,  had  been  made  to  operating 
expenses.  In  order  to  enable  such  a  scrutiny  to  be  made, 
the  figures  should  be  presented  in  such  a  manner  and  in 
such  detail  that  there  can  remain  no  doubt  in  the  minds 
of  the  court  or  commission  as  to  the  propriety  of  their 
admission  as  a  portion  of  the  cost  of  developing  the  busi- 
ness of  the  undertaking. 


CHAPTER  VII 

COMMERCIAL  VALUE 

83.  Three  figures  to  be  presented  under  head  of  commercial  value. 

84.  Relative  importance  of  figures  representing    the  market  value    of 

stocks  and  bonds. 

85.  Method  to  be  used  in  ascertaining  the  market  value  of  stocks  and 

bonds. 

86.  Method  of  ascertaining  value  based  on  capitalization  of  net  earnings. 

87.  Liabilities. 

83.  Three  figures  to  be  presented  under  head  of  com- 
mercial value.  —  What  is  here   called  the  commercial 
value  of  an  undertaking  is  distinctly  different  from  the 
values  derived   by  the  methods  which  have  just  been 
described,  in  that  the  values  are  determined  in  no  way 
analytically  but  are  based  upon  market  values  deter- 
mined either  by  the  prices  which  the  public  is  paying  for 
the  securities  of  the  undertaking  or  by  a  capitalization  of 
its  earnings.     There  are  thus  two  distinct  commercial 
values,  —  one  the  market  values  of  the  stocks  and  bonds, 
and  the  other  the  capitalization  of  the  net  earnings.     In 
addition  to  these  two  figures  is  a  third,  the  liabilities  of 
the  undertaking.     This  last  figure  should  be  presented  in 
detail  and  in  such  form  as  will  show  the  figure  definitely 
demanded  by  the  court,  viz.,  the  amount  and  par  value 
of  the  stocks,  bonds,  or  other  securities  which  the  under- 
taking has  issued. 

84.  Relative  importance  of  figures  representing  the 
market  value  of  stocks  and  bonds.  —  As  indicated  in 
section  9,  when  this  subject  was  presented,  there  have 
been  many  who  have  felt  that  this  figure,  if  developed 
with  care  and  with  proper  precautions,  was  more  reliable 


116  PUBLIC  UTILITIES 

than  those  obtained  by  the  more  artificial  methods 
required  in  a  determination  of  the  replacement  cost  or  of 
the  original  cost.  It  has  been  claimed  that  the  market 
value  "  represents  the  crystallization  of  the  best  judg- 
ment respecting  the  value  of  property";  that  it  repre- 
sents the  potential  value  of  the  property  more  nearly 
than  can  be  derived  in  any  possible  way  from  such 
methods  as  involve  the  capitalization  of  past  losses  or  a 
reproduction  of  a  hypothetical  new  property;  and  that 
it  recognizes  any  favorable  peculiarities  of  location  or  of 
operating  conditions  which  cannot  be  valued  by  any  arbi- 
trary, theoretical  or  analytical  determination  of  value. 
On  the  other  hand  the  Maine  Courts  have  said: 

"It  may  be  true  that  if  we  were  to-day  valuing  an  ordinary 
corporation  like  a  manufacturing  corporation,  a  mercantile  cor- 
poration, any  corporation  not  engaged  in  the  public  service, 
public  utility  corporation,  it  might  be  that  one  way  of  measur- 
ing its  value  over  and  above  the  physical  value  would  be  to 
get  at  the  value  of  its  stock  sold  in  the  market.  The  people 
who  bought  and  sold  such  stock  may  be  fairly  supposed  to  know 
what  they  are  buying  and  selling,  and  what  the  rights,  what 
the  limitations  upon  such  corporations  are.  There  is  no  lim- 
itation to  the  amount  of  money  which  such  corporation  is 
entitled  to  earn  if  it  can  get  it;  no  limitation  outside  of  the  char- 
ter as  to  the  lines  of  business  in  which  men  engage.  All  the 
things  which  seem  to  establish  the  value  of  such  stock  may  be 
fairly  known,  may  be  fairly  presumed  to  be  in  the  considera- 
tion of  the  men  who  bought  and  who  sold.  But  when  you  come 
to  the  matter  of  a  public  service  corporation,  we  are  met  at 
the  very  outset  with  this  great  difference;  that  the  rights  of 
the  corporation  to  earn  money  are  limited,  that  is  to  say,  to 
earn  money,  to  make  a  charge  to  its  customers.  They  are 
limited  by  rules  of  law  which  are  not  easy,  always,  of  applica- 
tion, they  are  limited  by  rules  of  law  which  we  think  are  not  and 
cannot  be  deemed  to  be  within  the  knowledge  and  contempla- 
tion of  investors  in  its  stock.  It  would  be  rather  a  far  reach 
to  say  that  investors  even  contemplated  the  physical  plant, 
the  most  of  which  is  out  of  sight.  Of  course  this  is  a  matter 


COMMERCIAL  VALUE  117 

which  would  rather  go  to  the  weight  of  the  evidence.  There 
are  elements  in  it  of  law,  the  application  of  legal  principles 
which  in  our  judgment  remove  it  from  the  rule  which  might 
perhaps  properly  be  applied  to  a  business  corporation;  and  it 
is  because  of  this  unknown  and  unknowable  element  of  the 
legal  application  of  rules  to  the  rate  question  that  we  think  the 
testimony  is  beyond  the  limit  of  admissibility."  1 

Three  other  decisions  only  need  be  quoted  to  show  the 
tenor  of  court  rulings  on  this  matter: 

"  Again,  when  property  has  been  capitalized  by  issuing  stock, 
neither  the  market  value  nor  the  par  value  of  the  stock  can  be 
accepted  in  all  cases  as  a  proper  criterion  of  value,  because  the 
stock  may  not  represent  the  money  actually  invested,  and, 
furthermore,  because  the  property  may  have  been  capitalized 
mainly  with  reference  to  its  income-producing  capacity,  on  the 
assumption  that  it  is  ordinary  private  property,  which  the  owner 
may  use  as  he  thinks  proper,  without  being  subject  to  legisla- 
tive control."  2 

"The  aggregate  value  of  bonds  and  issued  capital  stock  of 
the  company  at  present  market  prices  is  not  a  reliable  index 
of  the  value  of  the  plant,  because  such  prices  often  rise  and 
fall  from  the  operation  of  causes  which  have  little  or  nothing 
to  do  with  the  real  intrinsic  value  of  the  property,  and  the 
bonded  or  other  indebtedness  of  the  Company  may  exceed  the 
actual  value  of  its  property."  3 

"It  is  well  known  from  experience  that  public  utilities  are 
mostly  over-capitalized,  and  that  the  par  value  of  their  out- 
standing securities  usually  exceeds  the  actual  investment  in 
the  property  that  is  used  and  useful  in  connection  with  the  serv- 
ices they  render  to  the  public.  In  fact,  the  bonds  alone  often 
amount  to  more  than  the  cost-value  of  this  property.  The 
reasons  for  this  are  easily  explained.  They  are  found  in  the 
fact  that  in  capitalizing  the  plants,  whether  for  the  purposes 
of  consolidation  or  otherwise,  securities  are  often  issued  not 
only  against  actual  and  other  costs,  but  against  estimated 

1  Ruling  of  Supreme  Court  in  Portland  Water  Works  Valuation.     See 
Trans.  Amer.  Soc.  Civil  Engs.,  Vol.  LX1V,  p.  60,  1909. 

2  Cotting  v.  Kansas  City  Stock  Yards  Co.  et  al.,  82  Fed.  854  (1897). 

3  Spring  Valley  Water  Works  v.  San  Francisco  et  al.,  192  Fed.  145 
(1911). 


118  PUBLIC  UTILITIES 

monopoly  profits,  future  increases  in  the  business,  estimated 
savings  in  expenses  and  many  other  elements  of  this  nature. 
Not  only  this,  but  investigators  of  such  matters  feel  that  the 
greater  proportions  of  the  consolidation  of  business  interests 
during  the  past  three  decades  have  had  their  sources  in  the 
opportunities  for  private  gains  that  were  offered  to  insiders 
in  connection  therewith,  through  unlimited  security  issues  and 
the  rigging  of  the  markets  by  which  these  securities  were  un- 
loaded upon  the  public  at  prices  that  netted  such  insiders  large 
profits.  In  the  public  utility  field,  where  monopolistic  conditions 
largely  obtain,  the  opportunities  for  such  practices  have  been 
relatively  large.  That  security  issues,  based  on  such  conditions, 
cannot  often  fairly  measure  either  actual  investments  in,  or 
fair  value  of,  the  property  they  represent,  is  rather  obvious. 
It  is  equally  clear  that  excessive  capital  issues  of  this  sort  can- 
not ordinarily  constitute  a  fair  and  equitable  basis  for  the 
valuation  upon  which  the  rates  charged  for  the  services  rendered 
to  the  public  should  be  fixed." 

"  Operators  in  public  utilities  who  fail  to  use  ordinary  business 
judgment,  either  in  the  location,  construction,  or  management 
of  the  same,  or  who  incur  unnecessary  and  excessive  obligations 
in  other  ways,  should  not  be  permitted  to  shift  such  extra  costs 
upon  the  public.  It  is,  in  fact,  to  prevent  such  shifting  and 
other  unfair  practices  of  this  kind,  which  are  possible  under 
monopolistic  conditions,  that  public  utilities  have  been  placed 
under  government  regulation."  1 

While  the  above  decisions  indicate  that,  although  for  a 
private  enterprise  the  market  value  of  its  securities  may 
be  a  satisfactory  way  of  measuring  the  value  of  the  prop- 
erty over  and  above  the  value  of  the  physical  plant,  still  for 
a  public  utility  the  figures  representing  market  value  must 
be  used  with  caution  and  possibly  be  of  relatively  little 
value.  Notwithstanding  such  cautionary  rulings,  there  can 
be  no  question  that  such  a  figure  is  of  great  assistance  to 
a  tribunal  in  forming  a  decision  as  to  what  the  value  in- 
herent in  the  property  as  a  going  concern  really  is. 

i  Wis.  R.  R.  Com.  Rpts.,  Vol.  XI,  pp.  84  and  85  (1912). 


COMMERCIAL  VALUE  119 

The  method  to  be  used  in  deriving  this  figure  will  be 
very  briefly  described. 

85.  Method  to  be  used  in  ascertaining  the  market 
value  of  stocks  and  bonds. — The  problem  of  ascertaining 
the  true  market  value  of  stocks  and  bonds  would  be  an 
extremely  simple  one  if  the  market  quotations  as  of  the 
date  of  the  appraisal  could  be  accepted.  This  cannot  be 
done,  however,  owing  to  the  market  fluctuations  produced 
largely  by  speculative  interests.  Iii  the  long  run  it  is 
the  investing  interest  rather  than  the  speculative  inter- 
est which  controls  and  determines  the  prices  of  securities. 

"With  the  view  of  arriving  at  a  price  which  shall  fairly  rep- 
resent the  value  of  the  property,  the  course  of  the  movement 
of  prices  must  be  examined  over  a  sufficiently  long  period  of 
time  to  warrant  the  assumption  that  the  fluctuations  caused 
by  the  manipulations  of  trader  and  speculator  are  neutralized. 
How  long  such  a  period  should  be  must  be  determined  by  prac- 
tical judgment  in  each  specific  case.  A  cursory  examination 
of  the  course  of  prices  over  a  considerable  period  of  time  should 
be  made  in  all  cases.  Should  such  an  examination  show  the 
changes  to  have  been  comparatively  slight  and  the  course  uni- 
form, the  conclusion  would  be  warranted  that  a  comparatively 
short  period  prior  to  the  date  as  of  which  the  valuation  is  to 
be  made  is  sufficient.  If  the  changes  are  violent  and  appar- 
ently capricious,  a  greater  period  of  time  should  be  chosen."  *• 

What  it  is  desired  to  obtain  is  a  figure  representative 
of  the  true  present  market  value  of  the  stocks  and  bonds 
of  the  undertaking  freed  from  the  fluctuations  produced 
by  speculative  interests,  freed  from  daily  fluctuations, 
and  from  changes  in  prices  due  to  the  anticipation  of 
dividend  or  interest  payments. 

As  has  been  stated,  the  elimination  of  fluctuations  from 
speculative  buyers  can  be  accomplished  by  the  use  of 
prices  for  sales  extending  over  a  sufficient  time  in  the  past. 

1  Bulletin  21,  (1905),  United  States  Department  of  Commerce  and 
Labor,  p.  22. 


120  PUBLIC  UTILITIES 

Daily  fluctuations  can  be  cared  for  most  accurately, 
probably,  by  finding  the  weighted  mean  value  of  all  sales 
during  the  period  chosen  for  examination.  This  can  be 
found  by  dividing  the  total  amount  paid  for  the  secu- 
rities during  the  period  of  examination  by  the  number 
actually  sold. 

It  is  probable  that  in  most  cases  the  third  cause  of 
variation  would  not  be  the  source  of  appreciable  error 
if  neglected,  particularly  if  the  period  chosen  for  exam- 
ination was  sufficiently  long.  This  fluctuation  would 
not  be  present  in  the  case  of  a  bond  sold  "flat,"  and,  if 
sales  are  quoted  with  accrued  interest,  the  amount  of 
accrued  interest  to  the  date  of  sale  should  be  subtracted 
from  such  quoted  price  in  order  to  obtain  the  true  value 
of  the  bond  itself  for  the  sale.  In  the  case  of  stock,  it 
can  be  cared  for,  particularly  if  the  stock  is  one  which 
pays  dividends  with  a  fair  degree  of  regularity,  by  reduc- 
ing the  market  price  for  each  sale  by  an  amount  equal 
to  the  expected  accrued  return,  analogous  to  the  accrued 
interest  on  bonds. 

The  figures  thus  determined  furnish  one  value  based 
on  commercial  considerations  to  be  used  in  an  investi- 
gation as  to  fair  present  value.  (For  complete  de- 
scription of  this  method  reference  should  be  made  to 
Bulletin  21,  United  States  Department  of  Commerce 
and  Labor.) 

86.  Method  of  ascertaining  value  based  on  capitaliza- 
tion of  net  earnings.  —  This  item  is  designed  to  meet 
Mr.  Justice  Harlan's  requirement  for  figures  showing 
"the  probable  earning  capacity  of  the  property  under 
particular  rates  established  by  the  statute,  and  the  sum 
required  to  meet  operating  expenses."  This  item  was 
summarized  in  section  5,  as  "Figures  showing  the  com- 
mercial or  capitalized  value  of  the  business  of  the  under- 
taking based  upon  present  as  well  as  possible  future 


COMMERCIAL  VALUE  121 

earnings,  i.e.,  the  probable  gross  earnings  less  present  or 
possible  future  operating  expenses." 

Thus  two  sets  of  figures  are  to  be  presented  in  cases 
where  a  statutory  rate  has  been  imposed,  —  one  as  of 
the  earnings  and  operating  expenses  under  prevailing 
rates,  the  other  under  the  proposed  statutory  rate.  For 
the  present  it  will  be  necessary  only  to  describe  the  first 
of  these  two  sets  of  figures. 

There  are  two  figures  which  require  careful  study  in  a 
determination  of  the  capitalization  of  net  earnings,  — 
one  operating  expenses,  and  the  other  the  proper  rate 
upon  which  the  capitalization  should  be  based. 

The  net  earnings  are  the  gross  earnings  less  operating 
expenses,  taxes  and  reserves  for  depreciation.  In  any  de- 
termination of  the  gross  earnings  for  the  purposes  of  valua- 
tion, both  of  these  items  should  be  examined  with  care  to 
see  that  there  have  been  included  in  them  only  such  pay- 
ments as  should  legitimately  be  charged  as  expenses. 
Thus  many  undertakings  have  charged  extensions  of  the 
plant  to  operating  expenses  and,  thereby,  reduced  the  net 
earnings  by  amounts  which  should  have  been  charged  di- 
rectly to  the  cost  of  the  plant.  In  other  cases  insufficient 
amounts  have  been  laid  aside  as  depreciation  reserves. 

It  will  be  seen  that  it  will  usually  be  an  extremely  diffi- 
cult question  to  determine  what  the  proper  depreciation  re- 
serve should  be  unless  this  method  of  valuation  is  pursued 
in  connection  with  an  appraisal  which  shows  the  replace- 
ment cost  and  depreciation  of  the  physical  property  of  the 
undertaking.  In  such  a  case,  the  depreciation  reserves 
can  be  estimated  with  a  reasonable  degree  of  accuracy. 

The  proper  rate  of  return  upon  which  the  capitaliza- 
tion of  net  earnings  should  be  based  is  the  rate  of  return 
which  the  investing  public  is  willing  to  receive  for  that 
particular  security.  Thus  if  the  market  value  of  the 
stock  of  the  undertaking  under  appraisal  has  been  found 


122 


PUBLIC  UTILITIES 


by  the  method  described  in  the  last  section  to  be  50  per 
cent  above  par  value  and  the  return  paid  stockholders 
is  6  per  cent  on  the  par  value,  then  clearly  the  stockholder 
figures  4  per  cent  as  the  fair  rate  of  return  on  his  invest- 
ment. The  proper  net  return  capitalized  on  a  4  per  cent 
basis  would  give  therefore  the  commercial  value  of  the 
undertaking.  If  the  stock  stood  below  par  and  paid 
no  dividends,  then  clearly  it  would  have  speculative 
value  only  and  could  be  given  no  commercial  value  on 
this  basis,  and  reliance  would  have  to  be  placed  largely 
upon  the  prices  of  the  securities  as  sold  on  the  market. 

It  should  be  noted  that  the  rate  upon  which  capitaliza- 
tion is  to  be  based  should  be  determined  with  the 
greatest  possible  accuracy,  for  the  reason  that  a  slight 
variation  in  the  rate  may  cause  an  enormous  variation  in 
the  capitalized  value.  It  is  necessary,  therefore,  that  the 
present  market  value,  one  of  the  quantities  essential  to 
the  determination  of  the  rate  for  capitalization,  should 
be  found  freed  from  all  fluctuations  and  should  be  deter- 
mined to  as  many  significant  figures  as  may  be  necessary 
to  secure  the  required  accuracy. 

87.  Liabilities.  —  The  usual  form  of  a  corporation 
balance  sheet  is  shown  below.  Figures  have  been  intro- 
duced for  ease  of  explanation. 


Assets 
Plant  —  Apparatus,  Etc 

Real  Estate 

Working  Capital  —  Cash   

Bills  and  Accounts  Receivable  .  . 

Supplies 

Stocks  and  Bonds  (outside  securities) 

Liabilities 

Capital  Stock   

Funded  Debt    

Bills  and  Accounts  Payable 

Reserves  —  Depreciation  of  Plant    . . 


$1,000,000 
500,000 
200,000 
200,000 
100,000 


$1,500,000 


500,000 

500,000 

$2,500,000 

$1,300,000 
500,000 
200,000 
500,000 

$2,500,000 


COMMERCIAL  VALUE  123 

It  will  be  noticed  that  the  figures  derived  to  show  orig- 
inal cost  and  replacement  cost  were  designed  to  be  used 
as  checks  upon  the  plant  account,  the  principal  item  in 
the  assets  of  the  undertaking.  Working  capital  con- 
sists of  cash  and  supplies  plus  "  Bills  and  Accounts  Re- 
ceivable." This  sum  in  a  valuation  must  be  reduced 
by  " Bills  and  Accounts  Payable"  which  is  carried  on 
the  books  as  a  liability.  Working  capital  can  be  obtained 
directly  from  the  books  of  the  undertaking  and  is  pre- 
sented with  the  other  figures  as  an  asset.  The  only  ques- 
tion involved  in  working  capital  is  whether  or  not  it  is 
of  proper  amount  for  the  successful  conduct  of  the  busi- 
ness of  the  undertaking.  Securities  of  outside  organiza- 
tions or  quick  assets  of  any  kind  are  also  entered  with 
the  other  property  but  are  properly  securities  held  to  make 
good  the  losses  in  value  of  the  plant  investment  in  perish- 
able property. 

The  tribunal  has,  therefore,  two  figures  to  test  the 
trial  balance  of  the  undertaking,  —  original  cost  plus 
two  constants,  working  capital  and  outside  securities; 
and  replacement  cost  plus  the  same  two  constants. 

The  demand  of  the  court  for  figures  to  show  the  par 
value  of  the  stocks  and  bonds  is  for  the  purpose  of  com- 
paring the  actual  liabilities  of  the  undertaking  with  its 
assets  as  given  not  only  by  the  company's  books  but  by 
the  original  cost  and  replacement  cost  plus  the  constants 
above  described.  The  item  of  "  Reserves  —  Deprecia- 
tion of  Plant,"  which  is  shown  as  a  liability,  is  always 
difficult  for  one  who  is  not  an  accountant  to  understand. 
In  order  to  eliminate  this  difficulty,  the  above  supposi- 
titious trial  balance  can  be  shown  in  a  form  which  would 
present  the  financial  condition  in  a  manner  suitable  in 
an  appraisal. 


124  PUBLIC  UTILITIES 

Assets 

Plant  —  Apparatus,  Etc $1,000,000 

Real  Estate  500,000 

Cost-new 1,500,000 

Loss  due  to  Depreciation   500,000 

Plant  Value $1,000,000 

Working  Capital    300,000 

Stocks  and  Bonds  (outside  securities)    500,000 

$1,800,000 

Liabilities 

Capital  Stock   : $1,300,000 

Funded  Debt    500,000 

$1,800,000 

The  above  statement  shows  the  present  value  of  the 
assets  balanced  against  the  liabilities,  and  it  is  this  figure 
of  the  liabilities  of  the  undertaking  which  the  tribunal 
must  have  as  one  of  the  guides  toward  the  true  present 
value. 


CHAPTER  VIII 

THE  WORTH  OF  SERVICE  TO  THE  CONSUMER 

88.  Decisions  as  to  worth  of  service. 

89.  Rates  based  on  different  substituting  plant  not  a  criterion  of  worth. 

90.  Rates  in  other  communities  not  a  criterion  of  worth. 

91.  Profit  inherent  in  worth. 

92.  Worth  of  service  to  be  measured  by  what  it  would  cost  the  public  to 

furnish  the  same  service. 

93.  Overbuilt  plant. 

88.  Decisions  as  to  worth  of  service.  — 

"It  cannot  be  said  that  a  corporation  is  entitled,  as  of  right, 
and  without  reference  to  the  interests  of  the  public,  to  realize  a 
given  per  cent  upon  its  capital  stock.  When  the  question  arises 
whether  the  legislature  has  exceeded  its  constitutional  power 
in  prescribing  rates  to  be  charged  by  a  corporation  controlling 
a  public  highway,  stockholders  are  not  the  only  persons  whose 
rights  or  interests  are  to  be  considered.  The  rights  of  the 
public  are  not  to  be  ignored.  It  is  alleged  here  that  the  rates 
prescribed  are  unreasonable  and  unjust  to  the  company  and  its 
stockholders.  But  that  involves  an  inquiry  as  to  what  is  rea- 
sonable and  just  for  the  public.  .  .  .  The  public  cannot  prop- 
erly be  subjected  to  unreasonable  rates  in  order  simply  that 
stockholders  may  earn  dividends.  The  legislature  has  the 
authority,  in  every  case,  where  its  power  has  not  been  restrained 
by  contract,  to  proceed  upon  the  ground  that  the  public  may 
not  rightfully  be  required  to  submit  to  unreasonable  exactions 
for  the  use  of  a  public  highway  established  and  maintained  under 
legislative  authority.  If  a  corporation  cannot  maintain  such  a 
highway  and  earn  dividends  for  stockholders,  it  is  a  misfortune 
for  it  and  them  which  the  Constitution  does  not  require  to  be 
remedied  by  imposing  unjust  burdens  upon  the  public."  * 

"The  contention  of  the  appellant  in  the  present  case  is  that 
in  ascertaining  what  are  just  rates  the  court  shall  take  into 

1  Covington  &  Lexington  Turnpike  Road  Co.  v.  Sandford,  164  U.  S. 
597  (1896). 


126  PUBLIC  UTILITIES 

consideration  the  cost  of  its  plant;  the  cost  per  annum  of  oper- 
ating the  plant,  including  interest  paid  on  money  borrowed 
and  reasonably  necessary  to  be  used  in  constructing  the  same; 
the  annual  depreciation  of  the  plant  from  natural  causes  result- 
ing from  its  use;  and  a  fair  profit  to  the  company  over  and 
above  such  charges  for  its  services  in  supplying  the  water  to 
consumers,  either  by  way  of  interest  on  the  money  it  has  ex- 
pended for  the  public  use,  or  upon  some  other  fair  and  equitable 
basis.  Undoubtedly,  all  these  matters  ought  to  be  taken  into 
consideration,  and  such  weight  be  given  them,  when  rates  are 
being  fixed,  as  under  all  the  circumstances  will  be  just  to  the 
company  and  to  the  public.  The  basis  of  calculation  sug- 
gested by  the  appellant  is,  however,  defective  in  not  requiring 
the  real  value  of  the  property  and  the  fair  value  in  themselves 
of  the  services  rendered  to  be  taken  into  consideration."  J 

The  fair  value  of  the  services  rendered  are  here  ruled 
as  a  figure  to  be  presented  in  a  determination  of  fair 
present  value.  The  same  figure  was  ruled  as  necessary 
by  Judge  Harlan  in  the  decision  already  quoted. 

"What  the  public  is  entitled  to  demand  is  that  no  more  be 
exacted  from  it  for  the  use  of  a  public  highway  than  the  ser- 
vices rendered  by  it  are  reasonably  worth." 

Similar  rulings  were  made  in  the  Maine  Water  cases: 

At  the  same  time,  the  public  have  the  right  to  "demand  that 
the  rates  shall  be  no  higher  than  the  services  are  worth  to  them, 
not  in  the  aggregate,  but  as  individuals."  "No  more  shall 
be  exacted  from  the  public  than  the  services  in  themselves 
are  worth  to  the  public  as  individuals."  2 

The  worth  of  a  water  service  in  such  connection  "is  the 
worth  to  the  customers  as  individuals,  but  as  individuals  mak- 
ing up  a  community  of  water  takers."  3 

The  question  at  issue  is  probably  most  clearly  defined 
by  Judge  Savage : 

1  San  Diego  Land  Company  v.  National  City,  174  U.  S.  757. 

2  Kennebec  Water  District  v.  City  of  Waterville  (1902),  97  Maine  185. 

3  Brunswick  and  Topsham  Water  Dist.  v.  Maine  Water  Co.    (1905), 
59  Atl.  537. 


WORTH  OF  SERVICE  TO  THE  CONSUMER  127 

"The  elemental  principles  as  thus  far  noted  may  be  summa- 
rized as,  on  the  one  hand,  the  right  of  the  company  to  derive  a 
fair  income,  based  upon'  the  fair  value  of  the  property  at  the_ 
time  it  is  being  used  for  the  public,  taking  into  account  the  cost 
of  maintenance  or  depreciation,  and  current  operating  expenses; 
and  on  the  other  hand,  the  right  of  the  public  to  have  no  more 
exacted  than  the  services  in  themselves  are  worth."  l 

This  ruling  is  based  on  the  decisions  of  the  United 
States  Courts  in  a  number  of  cases.  2 

89.  Rates  based  on  different  substituting  plant  not  a 
criterion  of  worth.  —  The  utility  under  investigation  may 
have  availed  itself  of  such  strategic  position  that  it  is 
able  to  furnish  service  more  cheaply  than  would  be  pos- 
sible from  a  substituting  plant  in  another  location.     The 
cost  of  this  less  favorably  situated  substituting  plant  can- 
not be  made  the  measure  of  worth  to  the  community  of 
the  service  that  it  is  enjoying  at  the  date  of  the  appraisal. 
The  measure  of  the  worth  must  be  based  upon  the  value 
of  the  plant  under  investigation. 

"But  when  he  devotes  his  property  to  public  use,  he  must 
submit  to  the  right  of  the  public  to  regulate  his  compensation 
for  such  use  down  to  what  is  just  both  to  himself  and  to  the  pub- 
lic, and  that  compensation  is  to  be  based,  not  on  the  cost  of 
the  next  available  substitute,  but  on  a  fair,  reasonable  value  of 
the  property  at  the  time  it  is  used  for  public  convenience."  3 

90.  Rates  in  other  communities  not  a  criterion  of 
worth.  —  The  courts  have  excluded  evidence  tending  to 
prove  the  worth  of  the  service  to  the  users  by  a  compari- 
son of  the  existing  rates  with  the  charges  for  similar 

1  Kennebec  Water  District  v.  City  of  Waterville,  54  Atl.  p.  14  (1902). 

2  See  Smyth  v.  Ames,  169  U.  S.  466. 

San  Diego  Land  and  Town  Co.  v.  Nat.  City,  174  U.  S.  739. 
Covington  and  Lexington  Turnpike  Road  Co.  v.  Sandford,  164  U.  S.  579. 
Cotting  v.  Kansas  City  Stockyards  Co.  183  U.  S.  79. 
Reagan  v.  Farmers'  Loan  &  Trust  Co.  154  U.  S.  362. 

3  Spring  Valley  Water  Co.  v.  City  and  County  of  San  Francisco,  165 
Fed.  691  (1908). 


128  PUBLIC  UTILITIES 

service  in  other  communities.  This  has  been  based  on 
the  fact  that  identical  plants  rarely  exist  in  two  places 
and  weight  cannot  be  given  readily  nor  intelligently  to 
the  different  causes  which  might  tend  to  make  the  cost  of 
the  service  or  worth  of  the  service  more  in  one  place 
than  in  another.  Evidently  with  the  object  of  finding 
some  method  by  which  the  value  of  the  service  to  the  pub- 
lic could  be  determined,  Judge  Savage,  in  the  Brunswick 
water  case,  ruled :  — 

In  estimating  the  value  of  a  public  service  "to  the  public 
or  customers,  one  of  the  elements  necessary  to  be  considered 
is  the  expense  at  which  the  public  or  customers,  as  a  com- 
munity, might  serve  themselves,  were  they  free  to  do  so,  and 
were  it  not  for  the  existence  of  the  practically  exclusive  fran- 
chises of  the  supplying  company.  Water  is  to  be  regarded  as 
a  product,  and  the  cost  at  which  it  can  be  produced  or  dis- 
tributed is  an  important  element  of  its  worth."  1 

91.  Profit  inherent  in  worth.  —  But  this  decision  must 
not  be  construed  literally.  The  community  granted  to 
the  undertaking  the  right  or  franchise  to  supply  the  util- 
ity, preferring  to  do  so  rather  than  raise  the  money  and 
incur  the  risk  incident  to  the  construction  and  operation 
of  a  service  which,  in  most  cases,  was  new  and  untried. 
By  the  granting  of  these  rights  it  seems  but  reasonable 
to  assume  that  the  community  was  willing  to  pay  some- 
what higher  rates  than  would  have  been  the  case  if  it 
had  undertaken  the  construction  and  operation  of  the 
business  itself.  In  the  Maine  cases  the  courts  have  held 
that  this  excess  must  be  a  matter  of  judgment  in  the  light 
of  all  existing  facts,  due  recognition  being  given  to  the  fact 
that  the  undertaking,  in  accepting  its  franchise,  tacitly 
accepted  whatever  hazards  there  might  be  in  the  busi- 
ness. Thus, 

1  Brunswick  and  Topsham  Water  Dist.  v.  Maine  Water  Co.  (1905), 
59  Atl.  543. 


WORTH  OF  SERVICE  TO  THE  CONSUMER  129 

"  Injustice  is  done  by  anything  that  fails  to  deal  equitably 
with  the  private  as  well  as  the  public  interests  involved.     It 
(a  fair  profit)  is  not  necessarily  regulated  by  what  others  would- 
now  make  the  venture  for  under  the  present  circumstances  and 
with  present  knowledge.'7 1 

92.  Worth  of  service  to  be  measured  by  what  it  would 
cost  the  public  to  furnish  the  same  service.  —  It  will 
be  seen  from  the  above  quoted  decisions,  that  the  worth 
of  the  service  of  a  public  utility  to  the  users  must  be 
based  upon  what  it  would  cost  the  public  to  itself  provide 
the  same  service  that  is  being  obtained  at  the  present  time 
from  the  undertaking.  It  would  be  measured,  there- 
fore, by  the  rates  which  would  have  to  be  paid  by  the 
users  to  produce  a  gross  income  sufficient  to  maintain  the 
plant,  pay  fixed  charges  and  operating  expenses,  and 
provide  an  adequate  annual  reserve  for  depreciation. 
The  investment  which  would  have  to  be  made  by  the 
public  to  enable  it  to  furnish  the  service  would  equal  the 
replacement  cost  of  the  existing  plant,  but  from  which 
no  depreciation  value  had  been  deducted  except  such  lack 
of  value  as  might  exist  from  the  presence  of  inefficient 
elements  in  the  existing  plant. 

It  must  be  remembered  that  the  figure  thus  derived  is 
simply  one  of  the  many  which  are  presented  to  provide 
the  Court  with  ample  data  upon  which  to  base  his  deci- 
sion as  to  the  present  value.  It  may  seem  as  if  this  figure 
was  simply  a  repetition  of  those  which  have  been  already 
discussed  but  presented  under  a  different  name.  In  a 
measure  this  is  true,  but  it  must  be  recognized  that  the 
only  measure  of  the  worth  of  a  service  to  the  users  must  be 
what  it  would  cost  them  to  provide  the  same  utility  them- 
selves. It  must  be  measured  by  the  cost,  at  the  date  of 
investigation,  of  a  new  plant  and  a  new  organization. 
It  cannot  be  measured  by  the  present  value  of  the  exist- 

1  Pennsylvania  Ry.  Co.  v.  Philadelphia  County,  68  Atl.  679  —  (1908). 


130  PUBLIC  UTILITIES 

ing  physical  plant  nor  by  the  cost  of  the  property  of  the 
existing  undertaking.  It  is  a  value  when  derived  as 
above  described  which  is  unfair  to  the  undertaking 
which  in  good  faith  has  created  and  maintained  its  plant 
and  business  in  that  it  takes  no  cognizance  of  the  profit 
which  the  undertaking  is  justly  and  legally  entitled  to 
receive.  A  proper  increment  must  be  added  by  the 
Court  to  this  figure  in  forming  his  decision  as  to  the  fair 
present  value. 

93.  Overbuilt  plant.  —  There  is  one  point  in  this  con- 
nection which  must  be  carefully  considered.  If  the  plant 
has  been  overbuilt,  so  that  its  capacity  exceeds  the 
present  demands  for  the  utility,  the  worth  of  the  serv- 
ice to  the  users  cannot  be  based  upon  the  reproduction 
value  of  the  abnormally  large  plant,  as  the  rates,  which 
would  have  to  be  paid  by  the  relatively  few  subscribers 
in  order  to  provide  a  gross  return  ample  to  pay  fixed 
charges,  maintenance  and  depreciation,  would  be  more 
than  the  service  was  worth.  In  such  a  case  the  worth 
of  the  service  would  be  such  rates  as  would  have  to  be 
paid  by  the  larger  number  of  users  for  which  the  plant 
has  been  designed.  The  worth  of  the  service,  the  fair 
rate,  would  be  that  which  will  yield  a  fair  return  upon 
the  property  then  in  use  or  useful  to  the  "then"  takers 
of  the  service  or  utility. 

The  determination  of  whether  a  plant  has  been  over- 
built or  not  is  a  simple  and  common  engineering  prob- 
lem. Every  plant  should  be  and  usually  is  designed  to 
meet  an  expected  reasonable  growth  in  the  number  of 
users.  It  would  be  an  extravagant  and  foolish  policy 
to  build  a  plant  of  such  size  as  will  meet  only  the  present 
needs  of  the  public,  and  to  make  repeated  enlargements 
to  care  for  an  increasing  number  of  users.  The  above 
rulings  cannot  and  must  not  penalize  both  the  under- 
taking and  the  public  by  any  such  short-sighted  and 


WORTH  OF  SERVICE  TO  THE  CONSUMER  131 

unbusinesslike  policy.  For  all  well-engineered  plants, 
forecasts  are  made  by  those  most  competent  to  foretell 
the  growth  of  the  community  and  the  probable  percent- 
age of  the  population  that  will  be  takers  or  users  of  the 
utility.  With  these  forecasts  before  him  the  engineer, 
on  the  basis  of  present  worths  and  known  costs  of  con- 
struction, can  design  the  plant  which  will  meet  these  pres- 
ent and  future  demands  of  the  public  with  the  least  total 
expenditure.  A  plant  thus  designed  and  constructed 
would  be  a  normal,  not  an  overbuilt  plant,  although  there 
would  be  at  all  times  spare  plant  to  meet  emergencies 
and  reasonable  normal  growth,  and  it  is  upon  such  a 
normal  plant  that  the  value  of  the  service  to  the  users 
must  be  based. 

A  good  illustration  of  an  overbuilt  plant  is  that  afforded 
by  the  plant  of  the  Tin  turn  Manor  Water  Company.1 
This  company  had  constructed  portions  of  its  plant  of  a 
size  that  would  not  be  required  for  fifty  years.  In  the 
findings  in  this  case,  it  was  held  that  it  was  the  right  of 
the  company,  if  not  its  duty  to  the  public,  to  provide  for 
a  reasonable  normal  growth,  but,  as  it  could  be  shown 
that  a  smaller  initial  plant  with  later  enlargements  was 
that  which  would  conform  to  the  best  engineering  and 
greatest  economy,  the  company  could  not  expect  a  return 
upon  the  fair  present  value  of  such  an  abnormally  large 
plant  as  was  then  in  existence.  This  case  is  of  further 
interest  as  the  ultimate  value  upon  which  rates  were 
based  was  found  by  discarding  practically  entirely  the 
original  and  replacement  costs  and  finding,  as  far  as  the 
physical  plant  was  concerned,  what  the  cost  of  a  plant 
would  have  been  to  provide  service  for  the  present  users 
and  for  such  reasonable  growth  as  good  engineering  and 
the  development  of  the  community  indicated. 

1  Long  Branch  Commission  v.  Tinturn  Manor  Water  Co.  (1905),  62  Atl. 
474. 


132  PUBLIC  UTILITIES 

"The  lots  or  others  may  be  required  some  time,  but  no  man 
can  determine  the  contingencies  of  the  future,  and  it  will  not 
do  to  burden  the  patrons  of  to-day  in  order  to  provide  for  pos- 
sible needs  of  those  of  five  or  ten  years  hence,  at  least  when  this 
is  conceded  not  to  be  necessary  in  order  to  provide  for  equal 
facilities  when  demanded.  This  property  should  not  be  in- 
cluded." J 

1  Cedar  Rapids  Gas-Light  Co.  v.  City  of  Cedar  Rapids.  120  N.  W. 
969  (1909). 

See  also  San  Diego  Land  and  Town  Co.  v.  Jasper,  189  U.  S.  446  (1903). 


CHAPTER  IX 

RESERVES  FOR  DEPRECIATION 

94.  Investment  in  perishable  property  a  wasting  asset 

95.  Authority  for  depreciation  reserves. 

96.  Current  repair  and  maintenance. 

97.  Salvage  value. 

98.  Wearing  value. 

99.  Importance  of  accurate  determination  of  probable  life  of  units. 

100.  Creation  of  depreciation  reserves. 

101.  Creation  of  reserve  fund  by  "sinking  fund"  method. 

102.  Creation  of  reserve  fund  by  "straight  line"  method. 

103.  Creation  of  reserve  fund  —  Authority  for  use  of  "sinking  fund  "  or 

"straight  line"  method. 

104.  Mean  life  of  plant. 

105.  Danger  of  misconception  of  mean  life. 

106.  Adoption  of  " sinking  fund "  or  "straight  line"  method  of  making 

reserves  in  practical  cases. 

107.  Straight  line  method. 

108.  Sinking  fund  method. 

109.  Reserves  invested  in  plant. 

110.  Reserves  for  depreciation. 

94.  Investment  in  perishable  property  a  wasting  asset. 

-  A  public  utility  invests  its  money  in  a  plant,  usually 
consisting  of  land,  buildings  and  machinery  of  various 
kinds,  for  the  purpose  of  providing  the  public  with  a 
service  or  utility  of  which  the  public  has  need.  The 
money  is  not  invested  for  the  purpose  of  gaining  profit 
by  sale  of  the  plant,  as  might  be  the  case  with  mines  or 
with  raw  material  to  be  manufactured,  but  for  the  pur- 
pose of  providing  a  utility  which  can  be  sold  at  such  a 
price  as  will  give  the  undertaking  a  reasonable  return  and 
profit  upon  the  investment.  But  in  the  operation  of  the 
plant  used  to  produce  the  utility  sold,  portions  wear  out 
or  become  obsolete,  inefficient  or  of  inadequate  size,  and, 
consequently,  have  to  be  replaced  in  the  course  of  time 


134  PUBLIC  UTILITIES 

by  new,  more  efficient  or  larger  units.  The  investment  in 
the  older  units  has  been  gradually  wasting  away  and, 
when  the  units  can  be  used  no  longer,  the  investment 
represented  by  them  ceases  to  be  a  portion  of  the  cap- 
ital used  for  the  benefit  of  the  public. 

When  a  unit  of  plant  has  become  unserviceable  for 
any  reason,  it  must  be  replaced  by  a  new  one.  The  cost 
of  the  new  unit  cannot  be  added  to  the  cost  of  the  orig- 
inal unit  as,  by  such  a  method,  the  capital  of  the  under- 
taking would  not  represent  properly  the  money  invested 
in  plant  in  use  and  useful  for  the  public.  The  original 
investment  in  the  unit  no  longer  serviceable  must  be 
removed  from  the  capital  account  and  the  cost  of  the  new 
unit  entered  in  that  account.  Thus  it  is  seen  that  after 
a  time,  in  most  public  utility  plants,  the  original  invest- 
ment in  many  units  has  wasted,  and  that  this  loss  in 
capital,  arising  from  time  of  use  or  service,  is  a  real  cost 
of  the  production  of  the  utility  or  service  furnished  to 
the  public,  and  must  be  charged  as  a  portion  of  the  cost 
of  service  and  paid  for  by  the  public  in  return  for  the 
service  which  it  obtains. 

With  this  understanding  it  is  apparent  that  the  gross  in- 
come of  the  undertaking  must  be  sufficiently  large  to  pay 
the  operating  expenses  and  taxes  of  the  organization  own- 
ing the  plant,  to  pay  the  annual  sums  required  for  an 
amortization  of  the  cost  of  the  plant  and  pay  to  the  stock- 
holders not  less  than  a  fair  return  upon  their  property. 

95.  Authority  for  depreciation  reserves.  —  The  right 
of  an  undertaking  thus  to  reserve  each  year  considerable 
sums  of  money  to  be  used  in  the  reconstruction  of  plant 
in  addition  to  the  payment  of  dividends  to  stockholders, 
has  been  the  subject  of  serious  contention  in  the  past 
and  some  of  the  earlier  decisions  of  state  courts  have 
been  against  such  a  practice.1  The  Supreme  Court  of 

1  See  118  Iowa  234  (1902) ,  118  Cal,  556. 


RESERVES  FOR  DEPRECIATION  135 

the  United  States,  in  a  recent  decision,  has  ruled  definitely 
the  necessity  of  public  service  corporations  safeguarding 
their  stockholders  and  the  public  by  making  ample 
reserves  to  prevent  the  waste  of  the  investment  in  the 
property  required  for  the  use  of  the  public.  A  portion 
of  this  decision  and  a  few  others  bearing  on  this  subject 
are  given  below. 

"A  water  plant,  with  all  its  additions,  begins  to  depreciate 
in  value  from  the  moment  of  its  use.  Before  coming  to  the 
question  of  profit  at  all  the  company  is  entitled  to  earn  a  suffi- 
cient sum  annually  to  provide  not  only  for  current  repairs 
but  for  making  good  the  depreciation  and  replacing  the  parts 
of  the  property  when  they  come  to  the  end  of  their  life.  The 
company  is  not  bound  to  see  its  property  gradually  waste, 
without  making  provision  out  of  earnings  for  its  replacement. 
It  is  entitled  to  see  that  from  earnings  the  value  of  the  prop- 
erty invested  is  kept  unimpaired,  so  that  at  the  end  of  any 
given  term  of  years  the  original  investment  remains  as  it  was 
at  the  beginning.  It  is  not  only  the  right  of  the  company  to 
make  such  a  provision,  but  it  is  its  duty  to  its  bond  and  stock- 
holders, and,  in  the  case  of  a  public  service  corporation  at  least, 
its  plain  duty  to  the  public.  If  a  different  course  were  pursued, 
the  only  method  of  providing  for  replacement  of  property  which 
has  ceased  to  be  useful  would  be  the  investment  of  new  capital 
and  the  issue  of  new  bonds  or  stocks.  This  course  would  lead 
to  a  constantly  increasing  variance  between  present  value  and 
bond  and  stock  capitalization — a  tendency  which  would  inev- 
itably lead  to  disaster  either  to  the  stockholders  or  to  the  pub- 
lic, or  both.  If,  however,  a  company  fails  to  perform  this  plain 
duty  and  to  exact  sufficient  returns  to  keep  the  investment 
unimpaired,  whether  this  is  the  result  of  unwarranted  divi- 
dends upon  over-issues  of  securities,  or  of  omission  to  exact 
proper  prices  for  the  output,  the  fault  is  its  own.  When, 
therefore,  a  public  regulation  of  its  prices  comes  under  ques- 
tion, the  true  value  of  the  property  then  employed  for  the 
purpose  of  earning  a  return  cannot  be  enhanced  by  a  consider- 
ation of  the  errors  in  management  which  have  been  committed 
in  the  past."  l 

1  Knoxville  v.  Knoxville  Water  Co.,  212  U.  S.  p.  13  (1909). 


136  PUBLIC  UTILITIES 

"A  tramway  company  lay  down  a  new  tramway.  Of  course 
the  ordinary  wear  and  tear  of  the  rails  and  sleepers,  and  so  on, 
causes  a  sum  of  money  to  be  required  from  year  to  year  in  re- 
pairs. It  may  or  may  not  be  desirable  to  do  the  repairs  all 
at  once,  but  if  at  the  end  of  the  first  year  the  line  of  tramway 
is  still  in  so  good  a  state  of  repair  that  it  requires  nothing  to 
be  laid  out  on  it  for  repairs  in  that  year,  still,  before  you  can 
ascertain  the  net  profits,  a  sum  of  money  ought  to  be  set  aside 
as  representing  the  amount  in  which  the  wear  and  tear  of  the 
line  has,  I  may  say,  so  far  depreciated  it  in  value  as  that  sum 
will  be  required  for  the  next  year  or  next  two  years.  It  appears 
to  me  that  you  can  have  no  net  profits  unless  this  sum  has  been 
set  aside.  When  you  come  to  the  next  year,  or  the  third  or 
fourth  year,  what  happens  is  this:  As  the  line  gets  older  the 
amount  required  for  repairs  increases.  If  you  had  done  what 
you  ought  to  have  done,  that  is,  set  aside  every  year  the  sum 
necessary  to  make  good  the  wear  and  tear  in  that  year,  then  in 
the  following  years  you  would  have  fund  sufficient  to  meet  the 
extra  cost."  l 

"  Depreciation  should  be  met  out  of  the  earnings  and  should 
be  charged  to  operating  expenses.  In  no  case  should  it  be 
charged  to  the  construction  account,  or  be  met  by  the  proceeds 
of  the  sale  of  stocks  or  bonds,  or  other  forms  of  fixed  capital 
liabilities.  This,  at  least,  is  the  general  rule  and  holds  good 
except  perhaps  as  a  temporary  expedient  under  abnormal 
conditions."  2 

"  Depreciation  is,  properly  speaking,  an  operating  expense 
and  should  be  charged  or  treated  as  other  operating  expenses. 
A  plant,  that  is  not  earning  enough  to  meet  depreciation,  is  a 
losing  proposition."  3 

96.  Current  repair  and  maintenance.  —  An  under- 
taking is  entitled  to  a  return  sufficient  to  pay  a  fair  return 
upon  the  tnie  value  of  its  investment  in  property  useful 
to  the  public  after  paying  reserves  for  depreciation  and 
proper  operating  expenses.  Operating  expenses  include 
not  only  the  salaries  and  wages  of  all  employees  and  other 
well  established  costs  involved  in  the  production  of  the 

1  16,  Ch.  D.  347n  (1879). 

2  Wisconsin  Commission,  Vol.  II,  p.  154.  3  Ibid.,  p.  406. 


RESERVES  FOR  DEPRECIATION  137 

utility  sold,  but  also  the  costs  of  the  material  and  labor 
required  to  maintain  all  plant  units  in  efficient  and  suc- 
cessful operation. 

This  expense  for  maintenance  must  be  distinguished 
from  the  cost  of  renewals,  although  for  certain  classes  of 
repair  work  the  actual  dividing  line  is  frequently  difficult 
to  draw  except  by  a  more  or  less  arbitrary  ruling.  A 
general  rule  which  can  be  safely  followed  is  that,  whefe^ 
plant  is  in  any  way  renewed  or  replaced,  the  cost  of  labor 
and  material  consumed  in  such  work  must  be  defrayed 
from  the  reserves  for  depreciation.  Where  there  are  no 
such  renewals  or  renewals  are  of  a  trifling  nature,  the  cost 
should  be  considered  a  portion  of  the  operating  expense 
under  the  head  of  maintenance. 

In  reality  the  distinction  between  cost  of  renewals 
and  cost  of  maintenance,  or,  as  they  are  frequently 
called,  the  "cost  of  current  repair,"  is  more  or  less  theoret- 
ical rather  than  practical.  This  distinction  has  been  the 
cause  of  many  misunderstandings  and  controversies. 
The  explanation  of  these  controversies  probably  lies  in 
the  fact  that,  in  many  of  the  older  plants  of  large  under- 
takings, there  are  many  short-lived  elements  of  relatively 
small  value,  the  replacement  of  which,  on  account  of  wear 
and  tear,  obsolescence  or  inadequacy,  is  of  almost  uniform 
yearly  occurrence.  The  uniformity  and  regularity  with 
which  such  renewals  are  made,  it  is  argued,  places  the 
cost  of  renewals  in  the  same  category  as  current  repairs, 
and  a  distinction  between  the  cost  of  renewals  to  be  paid 
from  depreciation  reserves  and  the  cost  of  current  repair 
and  maintenance  to  be  treated  as  an  operating  expense, 
is  unnecessary.  But  the  facts  are  that  plants  contain 
some  units  of  considerable  cost  and  of  a  life  greater  than 
the  average  lives  of  most  of  the  other  units.  When  the 
renewal  of  these  expensive  units  becomes  necessary,  there 
will  be  required  sums  of  money  much  greater  than  would 


138  PUBLIC  UTILITIES 

be  needed  for  the  up-keep  and  normal  renewals  of  other 
years.  Such  abnormal  drains  upon  the  treasury  of  the 
undertaking  can  be  avoided,  if,  during  the  life  of  the  unit, 
there  had  been  set  aside  each  year  a  sufficient  sum  to 
aggregate,  at  the  time  of  the  renewal,  the  original  cost 
of  the  unit.  In  this  way  the  abnormal  demands  of  some 
years  for  means  to  make  the  necessary  renewals  of  the 
plant  are  met  by  the  contributions  to  the  depreciation 
reserve  fund  made  during  a  number  of  preceding  years. 
Possibly  another  way  of  looking  at  this  question  may 
make  this  clearer.  An  undertaking,  upon  the  best  judg- 
ment of  its  experts,  finds  that,  for  the  up-keep  of  its  plant 
and  for  the  renewals  of  unserviceable  units,  there  is  need 
each  year  of  contributions  from  income  of,  let  us  say, 
12|  per  cent  of  the  plant  cost.  The  costs  of  small  repairs 
and  renewals,  which  it  finds  necessary  to  make  during 
this  year,  are  charged  against  this  reserve  fund,  as  well 
as  the  costs  of  units  that  have  to  be  replaced  that  year. 
It  is  possible  that  during  that  year  10  per  cent  of  the  cost 
of  the  plant  is  spent  for  these  two  purposes,  thus  leaving 
2  J  per  cent  of  the  12 \  per  cent  reserved  remaining  unex- 
pended. This  2 1  per  cent  remaining  this  year  is  held  in 
funds  or  otherwise  as  a  depreciation  reserve  to  help  defray 
the  costs  of  renewals  which  in  some  later  years  may  be 
greater  than  could  be  met  by  the  12  J  per  cent  usually 
reserved  each  year.  Further,  the  necessity  of  treating 
the  costs  of  renewals  as  a  definite  item  of  expense  and 
making  reserves  to  defray  such  costs  is  very  conspicu- 
ous in  the  case  of  a  new  plant  which  may  not  reach,  for 
many  years,  such  a  condition  as  was  cited  above  where 
the  sum  of  the  costs  of  maintenance  and  renewals  was 
substantially  uniform  year  by  year.  During  a  term  of 
years  until  renewals  have  to  be  made  with  a  fair  degree 
of  regularity,  current  repairs  and  maintenance  will  be 
necessary,  but  as  there  is  no  actual  immediate  demand 


RESERVES  FOR  DEPRECIATION  139 

for  money  for  renewals,  appropriations  for  that  purpose 
from  the  yearly  income  might  not  be  made  as  they  should. 
It  is  with  the  object  of  emphasizing  the  necessity  of  pro- 
viding for  future  rather  than  possible  present  demands, 
that  the  distinction  between  current  repair,  an  annual 
operating  expense,  and  renewals,  a  charge  against  a  fund 
designed  to  make  such  cost  a  uniform  annual  expense  in 
operating  the  undertaking,  is  made. 

97.  Salvage  value.  —  From  what  has  been  said  above 
it  will  be  understood  that  the  investment  of  an  under- 
taking in  many  units  of  plant  is  wasting;  that,  when  a 
renewal  is  required,  the  cost  of  the  original  unit  must 
be  removed  from  the  plant  account  as  an  asset  and  the 
cost  of  the  replacing  unit  entered  as  a  portion  of  the  cost 
of  the  plant.     Moreover,  it  has  been  explained  that  the 
cost  of  the  original  unit  must  be  recovered  by  an  amortiza- 
tion, in  the  form  of  reserves  made  annually,  in  such  a 
way  that  the  original  cost  of  the  unit  will  be  on  hand  in 
the  reserve  funds  when  the  renewal  has  to  be  made. 

The  above  statement  is  not  strictly  accurate,  for  the 
reason  that  expense  may  be  incurred  in  removing  the 
old  unit  from  the  plant  and,  in  many  cases,  the  old  unit 
may  have  some  value  as  scrap  or  second-hand  material. 
The  difference  between  the  scrap  value  of  the  unit  and  its 
cost  of  removal  is  the  salvage  value  of  the  unit.  Salvage 
may  be  positive  or  negative  depending  upon  whether  the 
scrap  value  exceeds  the  cost  of  removal  or  not. 

Clearly  it  is  the  difference  between  the  original  cost 
and  the  scrap  value  of  the  unit  that  is  the  wasting  asset 
of  the  undertaking  represented  by  the  unit.  This  figure 
represents  the  sum  of  money  which  must  be  acquired, 
through  the  depreciation  reserves,  to  make  good  this  loss 
in  the  value  of  the  investment  resulting  from  the  removal 
of  the  unit  at  the  time  when  it  has  to  be  replaced. 

98.  Wearing  value.  —  This  loss  of  capital  represented 


140  PUBLIC  UTILITIES 

by  the  difference  between  the  original  cost  and  the  sal- 
vage value  is  frequently  called  the  " wearing  value"  of 
the  plant  or  plant  unit. 

99.  Importance  of  accurate  determination  of  probable 
life  of  units.  —  As  the  reserves  required  to  meet  the  cost 
of  renewals  must  be  obtained  by  increments  derived 
from  income  each  year  during  the  life  of  the  plant,  it  is 
necessary  for  the  management  to  forecast,  with  care  and 
skill,  the  number  of  years  that  it  is  probable  that  each 
unit  of  plant  can  be  retained  in  service,  and  from  these 
figures  derive  the  composite  life  of  the  plant  as  a  whole. 
This  problem  is  one  requiring  engineering  knowledge  and 
familiarity  with  the  art  upon  which  the  service  of  the 
utility  depends.     It  is  of  such  importance  that  it  will 
be  fully  discussed  in  the  following  chapter. 

But  there  is  a  second  problem  involved  in  the  creation 
of  reserves  for  renewals  which,  when  the  probable  life 
has  been  determined,  is  one  of  accountancy.  This  sec- 
ond problem  is,  with  a  known  " wearing  value"  and  an 
estimated  probable  life  for  a  unit,  how  large  increments 
should  be  set  aside  each  year  in  order  that  the  capital  cost 
of  the  unit,  as  represented  by  its  wearing  value,  may  be 
in  hand  at  the  time  when  a  renewal  must  be  made.  This 
accounting  problem  is  that  of  the  creation  of  reserves  for 
renewals. 

100.  Creation  of  depreciation  reserves.  —  In  what  has 
been  said  above  it  has  been  attempted  to  show  that  the 
investment  in  perishable  property  is  a  wasting  one  and 
that  to  offset  such  waste  the  loss  in  capital  must  be  made 
good  by  an  amortization  of  such  capital  loss  during  the 
period  of  probable  usefulness  of  the  property  affected; 
that  the  capital  loss  is  the  difference  between  the  cost 
and  the  salvage  value,  frequently  called  the  "  wearing 
value"  of  the  property;   that  this  amortization  is  cared 
for  by  sums  of  money  set  aside  from  income  each  year 


RESERVES  FOR  DEPRECIATION  141 

of  such  an  amount  that  at  the  end  of  the  period  of  service- 
ability there  will  be  in  hand  and  available  for  the  replace- 
ment of  the  unserviceable  property  a  sum  equal  to  the 
wearing  value  of  that  property;  that  the  sums,  thus  set 
aside  as  an  amortization  fund,  are  usually  termed  reserves 
for  depreciation.  Thus,  with  a  wearing  value  and  a 
period  of  serviceability  established  by  the  exercise  of  the 
best  expert  judgment,  the  economic  question  arises  as 
to  the  treatment  of  the  amortization  or  depreciation 
reserve  funds. 

As  a  practical  matter  the  treatment  of  this  fund  will 
differ  depending  upon  the  conditions  under  which  the 
undertaking  may  be  operating.  For  a  well-established, 
successful  and  growing  undertaking,  it  may  be  found 
best,  from  a  business  point  of  view,  to  invest  the  amor- 
tization reserves,  set  aside  each  year  from  income,  in 
needed  extensions  of  the  plant.  In  another  case,  sim- 
ilar to  the  above  but  where  there  is  not  the  necessity  for 
such  a  great  extension  of  plant  as  will  require  all  of  the 
reserve  funds,  a  portion  may  be  invested  in  plant  and  a 
portion  placed  at  interest  in  readily  convertible  securities. 
In  still  other  cases,  particularly  where  undertakings  are 
not  so  well  established  that  new  funds  can  be  easily 
secured  or  are  not  expanding,  the  entire  reserves  for  depre- 
ciation may  be  invested  most  properly  in  safe  and  read- 
ily convertible  securities  upon  which  some  return  can  be 
obtained.  In  each  one  of  these  cases,  the  capital  invested 
in  the  property  is  made  good  and  held  good,  but  in  each 
case  the  contributions  to  the  reserve  fund,  made  from 
income  each  year,  may  be  different. 

101.  Creation  of  reserve  fund  by  "sinking  fund" 
method.  —  If  the  reserves  for.  depreciation  are  to  be 
drawing  interest,  —  as  they  should  be  if  invested  in  secu- 
rities of  other  undertakings, — the  amount  to  be  laid  aside 
from  the  income  of  the  undertaking  under  consideration 


142  PUBLIC  UTILITIES 

would  be  less  than  if  no  interest  were  obtained,  as  the  fund 
would  have  the  benefit  of  the  interest  accumulations. 
The  amount  to  be  set  aside  each  year,  therefore,  is  an 
annuity,  which,  at  the  obtainable  rate  of  interest,  will 
equal  in  the  aggregate  the  "wearing  value"  of  the  prop- 
erty at  the  end  of  its  Me.  This  method  of  creating  depre- 
ciation reserves  is  known  as  the  "  sinking  fund  "  method. 

102.  Creation  of  reserve  fund  by  "straight  line" 
method.  —  In  case  depreciation  reserves  cannot  obtain 
the  benefit  of  interest  accretions,  the  amount  to  be  laid 
aside  each  year  would  be  the  amount  represented  by  the 
wearing  value  divided  by  the  years  of  serviceable  life. 
This  method  of  amortization  is  known  as  the  "straight 
line  "  method,  for  the  reason  that,  if  the  growth  of  the 
amortization  fund  were  plotted,  it  would  be  shown  as  a 
straight  line,  owing  to  the  equal  annual  increments.     A 
similar  curve  for  the  sinking  fund  method  would  not  be 
straight,  for,  although  the  annuity  paid  each  year  into  the 
fund  by  the  undertaking  would  be  equal,  yet  the  interest 
accretions  would  be  larger  and  larger  each  year. 

It  must  be  noted  that  at  the  end  of  the  life  of  each 
element  of  perishable  property,  whichever  method  is 
followed  either  "straight  line"  or  "sinking  fund,"  there 
will  be  an  equal  amount  on  hand,  i.e.,  the  wearing  value 
of  the  element,  but  that,  during  the  intervening  years, 
there  will  be  a  smaller  amount  in  the  reserves  for  de- 
preciation if  the  sinking  fund  method  is  employed  and 
interest  is  obtained  on  the  amounts  held  in  reserve. 

103.  Creation  of  reserve  fund  —  Authority  for  use  of 
"sinking  fund"   or   "straight  line"  method.  —  There 
has  been  and  probably  should   be  no  arbitrary  ruling, 
applicable  to  all  cases,  as  to  which  method  of  forming 
depreciation  reserves  should  be  followed  by  undertak- 
ings.    In  the  case  of  some  undertakings,  the  "straight 
line"  method  may  be  the  wiser,  with  others  the  "sinking 


RESERVES  FOR  DEPRECIATION  143 

fund"  method  and  with  still  others  a  combination  of  the 
two  methods.  The  method  to  be  employed  in  making 
depreciation  reserves  must  be  adopted  after  all  the  con- 
ditions affecting  the  economic  conditions  of  the  under- 
taking have  been  carefully  considered.  Thus  in  the  case 
of  many  undertakings  which  have  not  made  sufficient 
reserves  in  the  past,  there  is  a  desire  to  be  permitted  by 
the  courts  and  commissions  to  make  as  large  a  reserve 
for  depreciation  each  year  as  possible,  and,  in  conse- 
quence, the  straight  line  method  has  had  many  advo- 
cates. Commissions  have  also  ordered  the  use  of  the 
straight  line  method  in  cases  where  an  amortization  of 
overcapitalization  of  an  undertaking  was  desired.1  On 
the  other  hand,  commissions  have  favored  repeatedly  the 
sinking  fund  method.  In  one  case  it  was  said: 

"the  facts  obtained  tend  to  show  that  the  sinking  fund  method 
of  computing  depreciation  is,  on  the  whole,  fairer  than  the 
straight  line  method,  and  that  the  advantages  of  the  sinking 
fund  method  tend  to  increase  with  increases  in  the  average 
life  of  the  utilities/7  2 

"The  expense  of  this  substitution,"  i.e.,  replacement  of  old 
plant  by  new,  "which  does  not  increase  the  gross  earning  capac- 
ity cannot  be  fairly  charged  to  capital  account,  but  should  be 
defrayed  out  of  a  suitably  supported  depreciation  fund  which 
has  been  gradually  accumulated  out  of  the  earnings  during  the 
life  of  the  equipment,  and  which,  at  the  end  of  the  life  period, 
has  become  equal  to  the  first  cost  of  the  original  equipment 
diminished  by  the  amount  of  any  '  scrap '  value  or  salvage  which 
may  be  obtained  from  the  discarded  equipment.  Interest 
accretions  will  add  to  the  amount  as  the  fund  grows,  and  the 
annual  sum  set  aside  out  of  the  earnings  should  be  adjusted 
with  this  in  view.  Three  per  cent  is  a  conservative  rate  of 
interest  to  set  as  the  minimum  which  ought  to  be  accepted  on 
the  moneys  of  a  trust  fund,  within  which  category  this  depre- 
ciation fund  belongs."  3 

1  See  P.  S.  C.,  N.  Y.,  1st  Dist.,  Vol.  Ill,  p.  156. 

2  Wis.  R.  R.  Com.  Rpts.,  Vol.  IV,  p.  502. 

3  Rept.  Special  Tel.  Comm.,  Chicago,  Apr.,  1907,  p.  71. 


144  PUBLIC  UTILITIES 

104.  Mean  life  of  plant.  —  The  full  significance  of 
reserves  for  renewals  is  most  clearly  understood  when  the 
case  of  each  individual  unit  of  plant  is  considered.  In 
such  a  case  it  is  known  that  certain  relatively  small  sums 
will  have  to  be  paid  yearly  for  the  current  maintenance 
of  the  unit  but  that  the  capital  invested  will  be  active  in 
earning  its  portion  of  the  annual  charges  throughout  the 
life  of  the  unit.  If  one  unit  only  is  considered,  it  would 
seem  as  if  no  misunderstanding  could  occur  as  to  the 
importance  of  reserves  for  renewals  and  that  a  choice 
between  the  sinking  fund  method  or  the  straight  line 
method  was  of  no  material  importance,  except  so  far  as 
the  financial  question  of  new  money  was  concerned,  so 
long  as  the  fund  for  the  renewal  of  the  unit  had  reached 
its  wearing  value  at  the  time  when  it  had  to  be  replaced. 

But  in  practice  the  problem  is  not  so  simple.  The 
plants  of  most  large  public  service  corporations  are  made 
up  of  a  large  number  of  elements,  such  as  poles,  rails, 
wire,  generators  and  switchboards,  the  useful  life  of  each 
of  which  will  vary  greatly,  so  that  it  is  necessary,  in  order 
to  find  the  total  amount  to  be  set  aside  in  the  reserves 
for  renewals,  to  find  the  mean  life  of  the  entire  plant. 

It  will  be  well  to  keep  clearly  in  mind  the  fact  that 
the  present  discussion  relates  wholly  to  the  question  of 
the  necessary  reserves  for  renewals  and,  consequently,  the 
life  of  the  plant  and  its  wearing  value  are  the  only  figures 
involved.  Units  or  elements  may  have  been  installed 
at  different  dates  in  the  past  and,  consequently,  have 
entirely  different  ageSj  but  the  age  of  the  several  units 
has  no  bearing  whatever  upon  the  amount  required  for 
the  reserves  for  renewals.  The  amount  set  aside  each 
year  for  each  unit  is  the  same  for  each  year  of  its  life, 
that  is,  it  is  the  same  for  an  old  as  for  a  new  unit,  and, 
as  a  consequence,  the  increment  to  the  reserve  fund  for 
all  portions  of  the  plant  of  the  same  life  is  the  quotient 


RESERVES  FOR  DEPRECIATION  145 

obtained  by  dividing  the  sum  of  the  wearing  values  of 
all  such  portions  of  the  plant  by  the  number  of  years  of 
their  life.  Or,  in  the  case  of  a  large  plant  with  elements 
each  of  different  life,  the  mean  We  is  found  by  dividing 
the  sum  of  such  quotients  into  the  sum  of  the  wearing 
values  of  all  plant  elements,  i.e.,  the  wearing  value  of  the 
entire  plant.  This  can  be  illustrated  best  by  a  concrete 
case.  Let  the  wearing  value  of  all  plant  elements  that 
can  be  useful  for  5  years  be  $50,000;  for  10  years  be 
$100,000;  for  15  years,  $75,000;  for  20  years  be  $100,000. 
Then, 

$50,000  -r  5  =  $10,000 

100,000  -T-  10  =  10,000 

75,000  -r-  15  =   5,000 

100,000  -T-  20  =      5,000 

$325,000  $30,000 

This  shows  that  the  annual  reserves  should  be  $30,000, 
which  would  be  the  same  as  if  it  had  been  said  that  the 
entire  plant,  having  a  wearing  value  of  $325,000,  had  a 
mean  life  of  approximately  10.8  years  (325,000-^30,000). 

105.  Danger  of  misconception  of  mean  life.  —  In  the 
preceding  section  an  example  is  given  illustrating  the 
correct  method  of  determining  the  mean  life  of  a  prop- 
erty. When  thus  determined  the  mean  life  becomes  a 
figure  by  the  use  of  which  the  property  of  a  utility  in 
one  place  may  be  compared  with  a  similar  property  in 
another  place.  Naturally  local  conditions  may  have  an 
important  effect  in  causing  a  variation,  but,  generally 
speaking,  it  is  possible  to  say  that  the  mean  life  of  a  water 
plant  is  x  years,  of  a  gas  plant  y  years,  or  of  a  telephone 
plant  z  years. 

But  when  we  speak  of  the  mean  life  of  such  a  property 
as  was  considered  in  the  preceding  example  as  10.8  years, 
it  is  not  meant  that  $30,000  is  set  aside  each  year  for  10.8 
years  and  that  the  renewals  required  during  that  period 
are  not  made  when  required.  The  mean  life  is  simply 


146  PUBLIC  UTILITIES 

a  practical  figure  derived  by  a  careful  study  of  each  unit 
and  is  to  be  used  in  determining  the  annual  reserve  for 
the  plant  as  a  whole.  The  reserve  for  each  particular 
unit  is  made  each  year  and  is  held  for  that  unit  in  the 
funds  until  its  life  has  been  exhausted,  at  which  time  the 
wearing  value  of  that  unit  is  taken  from  the  reserve  to 
pay  the  cost  of  renewal  of  that  particular  unit. 

Possibly  the  idea  of  mean  life  will  be  clearer  if  the 
following  thought  is  kept  in  mind.  Take  the  case  used  in 
the  preceding  section  and  suppose  that  the  plant  does 
not  grow  and  that  the  plant  cost  does  not  change,  then,  so 
long  as  the  utility  is  in  existence,  using  units  which  have 
been  worn  out  and  replaced  time  and  again,  there  will 
have  to  be  set  aside  as  a  yearly  reserve  for  depreciation 
$30,000.  Mean  Me  is,  therefore,  simply  the  number  of 
years  which  will  elapse  before  an  amount  equal  to  the 
total  cost  of  the  perishable  property  will  have  been  paid 
from  revenue  for  reserves  for  renewals.  The  mean  life 
is  not  a  Me  dating  from  the  original  construction  of  the 
plant.  It  is  true  of  a  given  plant  at  any  time,  now  or 
in  the  future,  provided  the  plant  does  not  change  in 
character  or  in  cost. 

The  failure  to  appreciate  that  the  reserves  for  each 
unit  accumulate  for  the  benefit  of  that  unit  throughout 
that  unit's  life,  and  that  mean  life  is  simply  a  composite 
figure  useful  for  determining  what  proportion  of  the  total 
cost  of  the  plant  shall  be  set  aside  as  the  annual  reserve 
for  the  entire  perishable  property,  is  the  cause  of  most 
of  the  existing  misunderstanding  relative  to  the  sinking 
fund  method  of  accumulating  reserves  for  renewals  and 
the  cause  of  many  of  the  arbitrary  rulings  in  favor  of  the 
straight  line  method.1 

106.  Adoption  of  "sinking  fund"  or  "straight  line" 

1  See  Manhattan  Railway  Co.  v.  Woodbury,  203  N.  Y.  231,  (Oct.  17, 
1911). 


RESERVES   FOR  DEPRECIATION  147 

method  of  making  reserves  in  practical  cases.  —  The 

discussion  in  the  preceding  sections  of  this  chapter  has 
been  very  largely  theoretical  and  has  been  intended  to 
present  the  fundamental  principles  involved  in  maintain- 
ing the  capital  value  of  the  undertaking.  When  the 
practical  case  is  presented  to  the  management  of  a  pub- 
lic utility  as  to  which  basis  shall  be  adopted  in  making 
reserves  for  depreciation,  the  question  must  be  answered 
very  largely  by  a  decision  as  to  whether  the  reserves  for 
depreciation  are  to  be  invested  in  extensions  to  the  plant 
or  not.  If  the  reserves  are  to  be  invested  in  plant 
enlargements,  then  the  straight  line  method  must  be 
employed.  On  the  other  hand,  if  the  reserves  for  depre- 
ciation are  invested  in  outside  securities,  then,  as  such 
funds  have  the  benefit  of  interest  accumulations,  the  use 
of  a  straight  line  method  would  result  in  abnormally  large 
sums  being  set  aside,  and,  in  consequence,  the  sinking 
fund  method  is  to  be  preferred. 

107.  Straight  line  method. — The  reason  why  the 
straight  line  method  should  be  employed,  when  the 
reserves  for  renewals  are  invested  in  plant,  is  apparent 
when  the  operation  of  the  sinking  fund  method  is  con- 
sidered. This  can  be  understood  most  readily  by  a 
consideration  of  a  practical  example. 

Let  it  be  assumed  that  the  plant  of  an  undertaking  had 
cost  $100,000  (assuming  zero  salvage  value)  and  that  it 
had  a  mean  life  of  10  years.  Let  it  also  be  assumed  that 
the  undertaking  operating  the  plant  is  entitled  to  a 
return  of  eight  per  cent.  Then,  during  each  of  the  ten 
years,  the  gross  income  must  be  sufficient  to  pay  taxes, 
to  pay  the  operating  expenses,  to  pay  eight  per  cent  on 
the  investment  of  $100,000.00  and  to  pay  to  a  reserve 
fund  such  an  amount  as  will  aggregate  at  the  end  of  ten 
years  the  original  investment.  For  the  present  example, 
let  it  be  assumed  that  each  increment  to  this  fund  has 


148 


PUBLIC  UTILITIES 


been  invested  each  year  in  new  plant  needed  and  required 
by  the  public.  If  the  sinking  fund  method  is  employed 
in  figuring  reserves  for  renewals,  the  undertaking  must 
pay  not  only  the  annuity  but  the  interest  on  the  sinking 
fund.  If  the  straight  line  method  is  employed,  the  incre- 
ments to  the  reserve  fund  will  be  the  original  cost  divided 
by  the  years  of  life,  or  $10,000. 

The  operation  of  this  fund  for  each  year  of  life  by  each 
of  the  above  methods  of  accumulation  is  shown  hi  the 
following  table: 

TABLE  I 

YEARLY  INCREMENT  TO  DEPRECIATION  RESERVES  TO  COVER  ORIGINAL 

INVESTMENT 


ANNUITY  +  INTEREST 

YEAKLY  PAYMENTS 

Year 

Annuity 

Interest 

Sinking  Fund 
Method 

Straight  Line 
Method 

End  of  1st 

$6903 

$6903 

$10000 

2nd 

6903 

$552 

7455 

10000 

3rd 

6903 

1149 

8052 

10000 

4th 

6903 

1793 

8696 

10000 

5th 

6903 

2488 

9391 

10000 

6th 

6903 

3240 

10143 

10000 

7th 

6903 

4051 

10954 

10000 

8th 

6903 

4927 

11830 

10000 

9th 

6903 

5874 

12777 

10000 

10th 

6903 

6896 

13799 

10000 

$100000 

$100000 

From  this  it  is  seen  that,  by  the  sinking  fund  method, 
the  sums  of  the  payments  to  the  reserves,  for  annuity  and 
interest,  during  the  early  years  of  the  life  of  the  plant 
are  less  than  they  would  be  if  the  straight  line  method 
was  used,  but,  later  on,  the  annual  payments  to  the  sink- 
ing fund  become  very  much  larger,  in  the  10th  year 
$13,799  and  $10,000  respectively.  The  results  of  the 
two  methods,  however,  are  the  same,  in  that,  at  the  end 


RESERVES  FOR   DEPRECIATION  149 

of  the  life  of  the  plant,  there  has  been  accumulated 
$100,000  by  both  methods.  In  other  words,  there  has 
been  contributed  by  the  public  for  the  purpose  of  reserves 
$100,000  by  either  method  during  the  ten  years  that  the 
plant  has  been  useful. 

When  it  is  remembered  that  the  plant  is  made  up  of  a 
large  number  of  units,  which  have  been  brought  into 
service  at  different  dates,  and  is  composed  of  units  of 
different  lives,  it  will  be  appreciated  that  the  sum  of  the 
increments  for  the  reserves  for  each  unit  would  be  not  the 
amounts  shown  as  the  yearly  total  of  the  sinking  fund 
column  but  rather  figures  approaching  those  shown  in  the 
straight  line  column.  But  even  supposing  that  we  were 
dealing  only  with  a  single  plant  unit;  as  the  $100,000, 
the  entire  original  cost,  must  be  recovered  by  the  under- 
taking from  the  public,  clearly  it  is  simpler  and  more 
rational  to  make  the  payments  uniform  for  each  year  than 
to  set  up  an  artificial  method  such  as  that  of  the  sink- 
ing fund,  wherein  different  amounts  must  be  set  aside 
each  year.  It  is  true  that,  in  some  cases,  it  is  desirable 
to  make  the  burden  upon  the  public  as  light  in  the  early 
years  of  the  operation  of  an  undertaking  as  possible,  but, 
for  most  public  utilities,  such  an  argument  has  no  force. 
Moreover,  the  inequality  of  the  demands  for  deprecia- 
tion reserves  each  year  would  indicate,  at  least  theoret- 
ically, a  necessity  for  an  increasing  or  variable  charge 
for  the  service  or  utility  furnished. 

For  the  above  reasons  there  seems  to  be  no  question 
but  that,  when  reserves  are  used  for  needed  and  useful 
extensions  of  plant,  the  straight  line  method  of  making 
reserves  for  depreciation  should  be  employed. 

108.  Sinking  fund  method.  —  For  practical  reasons 
there  seems  to  be  no  doubt  as  to  the  desirability  of  mak- 
ing uniform  increments  each  year  to  the  reserves  for 
depreciation.  By  "uniform"  it  is  not  meant  that  the 


150  PUBLIC  UTILITIES 

same  total  amount  should  be  placed  in  reserve  each  year, 
but  that  there  should  be  set  aside  a  uniform  percentage 
of  the  wearing  value  of  the  plant  as  it  is  found  to  be  after 
additions  to  the  plant  or  removals  of  abandoned  plant 
have  been  properly  entered  as  positive  or  negative  fac- 
tors in  the  plant  account. 

If  the  depreciation  reserves  are  invested  in  outside 
securities,  the  interest  on  the  reserve  funds  is  paid  not  by 
the  public  but  by  those  having  the  use  of  the  money. 
Moreover,  the  amount  paid  by  the  public  as  an  annuity 
to  the  reserves  would  be  uniform  and  (if  8  per  cent  could 
be  obtained  for  such  money)  would  be  the  amount  shown 
as  the  annuity  in  the  above  table. 

Thus  it  is  seen  that,  provided  the  straight  line  method 
is  used  when  reserves  are  invested  in  plant  and  the  sinking 
fund  method  when  reserves  are  invested  in  outside  secu- 
rities, the  percentage  of  the  wearing  value  of  the  plant 
to  be  set  aside  each  year  is  uniform  in  each  method  but 
that  the  annual  payments  to  the  fund  for  renewals  are 
larger  when  the  straight  line  method  is  used  than  when  the 
sinking  fund  method  is  employed. 

109.  Reserves  invested  in  plant.  —  It  must  not  be 
inferred  that,  because  the  amount  paid  annually  as  a 
reserve  for  depreciation  is  less  with  the  sinking  fund 
method,  when  such  funds  are  invested  in  outside  secu- 
rities, than  with  the  straight  line  method,  the  sinking 
fund  method  is,  consequently,  more  favorable  to  the 
public  and  that  it  is  therefore  the  proper  method  to  be 
adopted  generally.  A  careful  consideration  of  this  ques- 
tion will  show  that  the  burden  upon  the  public  is  less  when 
the  straight  line  method  is  employed  than  it  would  be 
with  the  sinking  fund  method,  in  all  cases  where  the 
undertaking  is  in  successful  operation,  is  growing  and, 
consequently,  requires  new  money  with  which  to  carry 
out  needed  enlargements  or  extensions  of  the  plant. 


RESERVES  FOR  DEPRECIATION  151 

This  economic  question  is  of  such  fundamental  impor- 
tance that  it  will  be  discussed  somewhat  at  length.  The 
use  of  reserve  funds  for  plant  extensions  necessarily 
indicates  that  the  business  is  growing.  If  the  plant  is  of 
sufficient  size  for  all  immediate  needs,  then,  clearly,  the 
sinking  fund  method  is  the  only  plan  that  should  be  used. 
But  for  a  growing  property  the  management  has  two 
alternatives,  —  either  to  use  the  reserves  to  defray  the 
cost  of  plant  extensions,  or  to  obtain  new  money  from 
the  stockholders  for  that  purpose.  In  the  latter  case, 
the  public  will  have  to  pay  the  full  return  upon  the  stock- 
holders' investment ;  in  the  former  case,  the  new  plant 
would  be  provided  from  funds  upon  which  the  stock- 
holders can  obtain  no  return.  Where  reserves  are  in- 
vested in  plant,  the  undertaking  is  not  using  its  own 
money  for  such  extensions,  but  money  in  which  the  pub- 
lic has  an  interest,  and,  consequently,  the  public  be- 
comes to  a  certain  extent  a  partner  in  the  operations  of 
the  undertaking.  As  a  consequence  of  this  the  burden 
upon  the  public  is  somewhat  less  when  the  reserves  are 
invested  in  plant  than  would  be  the  case  if  the  stock- 
holders' money  was  used.  This  point  can  be  illustrated 
quantitatively  by  a  numerical  example. 

Let  the  cost  of  the  plant  be  taken  as  $100,000,  and  let 
it  be  supposed  that  the  plant  has  no  salvage  ^value.  Let 
the  rate  of  return  to  the  stockholders  of  the  undertaking 
owning  the  plant  be  8  per  cent  and  the  life  of  the  plant 
be  ten  years. 

Let  us  take  the  case  first  of  the  yearly  requirements 
when  the  reserves  are  invested  in  plant.  At  the  end  of 
the  first  year  $10,000  will  be  required  as  a  reserve  for 
depreciation.  With  this  $10,000  let  it  be  supposed  that 
new  plant  is  immediately  purchased.  The  new  plant 
will  have  a  life  of  ten  years.  At  the  end  of  the  first  year 
of  its  use,  i.e.,  at  the  end  of  the  second  year  of  the  exist- 


152 


PUBLIC  UTILITIES 


ence  of  the  plant,  a  reserve  must  be  set  aside  to  cover  the 
depreciation  of  the  plant  a  year  old  as  well  as  the  second 
installment  toward  the  depreciation  reserve  of  the  orig- 
inal plant.  So  that  at  the  end  of  the  second  year  $11,000 
must  be  set  aside,  i.e.,  $100,000  -+  10  and  $10,000  -v-  10. 
This  has  been  set  out  in  the  following  table :  — 

TABLE   II 

ILLUSTRATING  ACCUMULATION  OF  DEPRECIATION  RESERVES 


End  of' 
Year 

Amount 
set  aside 
each  Year 

1 

$10000 

$10000 

2 

10000  +  1000  

11000 

3 

10000  +  1000+  1100 

12100 

4 

10000'+  1000+  1100  +  1210  

13310 

5 

10000  +  1000+  1100  +  1210  +  1331  

14641 

6 

7 

10000  +  1000+  1100  +  1210  +  1331  +  1464  
10000  +  1000+  1100  +  1210  +  1331  +  1464  +  1610 

16105 
17715 

It  must  be  remembered  that,  in  accordance  with  the 
assumptions  of  this  example,  the  amounts  set  aside  each 
year  as  depreciation  reserves  are  invested  in  plant  and, 
in  consequence,  the  cost  of  the  plant  is  constantly  in- 
creasing by  the  increments  given  in  the  last  column  of 
Table  II.  The  stockholders'  original  investment  is  only 
SI 00,000,  but  the  cost  of  the  property  is  constantly 
increasing  with  yearly  increments  of  increasing  size. 
This  growth  in  cost  .of  the  plant  is  shown  in  column  2 
of  Table  III,  page  153.  Column  3  shows  the  condition 
of  the  investment  of  the  stockholders  in  the  undertaking. 
The  original  investment  made  by  them  in  the  plant  unit 
remains  unchanged  during  the  first  ten  years,  but  the 
total  amount  that  has  been  invested  increases  rapidly 
owing  to  the  reserves  that  must  be  made  to  maintain 
the  investment  intact.  At  the  end  of  the  ninth  year 
^here  has  been  expended  to  make  good  the  original  invest- 


RESERVES  FOR   DEPRECIATION 


153 


TABLE  III 

ILLUSTRATING  RELATIVE  INVESTMENTS  OF  STOCKHOLDERS  AND  OF  DEPRE- 
CIATION RESERVES  IN  A  RAPIDLY  EXPANDING  ENTERPRISE 


End  of 
Year 

Plant  Cost 

Stockholders' 
Investment 

Investment 
of  Reserves 

Mean  Age 

(1) 

(2) 

(3) 

(4) 

(5) 

0 

$100,000 

$100,000 

0 

0 

1 

110,000 

100,000 

$10,000 

.909 

2 

121,000 

100,000 

21,000 

1.735 

3 

133,100 

100,000 

33,100 

2.486 

4 

146,410 

100,000 

46,410 

3.169 

5 

161,051 

100,000 

61,051 

3.790 

6 

177,156 

100,000 

77,156 

4.355 

7 

194,872 

100,000 

94,872 

4.868 

8 

214,359 

100,000 

114,359 

5.335 

9 

235,795 

100,000 

135,795 

5.759 

10 

259,374 

200,000 

59,374 

2.289 

11 

285,311 

210,000 

75,311 

2.640 

12 

313,842 

221,000 

92,842 

2.958 

13 

345,227 

233,100 

112,127 

3.247 

14 

379,750 

246,410 

133,340 

3.511 

15 

417,725 

261,051 

156,674 

3.750 

16 

459,497 

277,156 

182,341 

3.968 

17 

505,447 

294,872 

210,575 

4.166 

18 

555,992 

314,359 

241,633 

4.346 

19 

611,591 

335,795 

275,796 

4.509 

20 

672,750 

459,374 

213,376 

3.171 

21 

740,025 

495,311 

244,714 

3.306 

22 

814,027 

534,842 

279,185 

3.429 

23 

895,430 

578,326 

317,104 

3.541 

24 

984,973 

626,159 

358,814 

3.642 

25 

1,083,470 

678,775 

404,695 

3.735 

26 

1,191,818 

736,652 

455,166 

3.819 

27 

1,310,999 

800,317 

510,682 

3.895 

28 

1,442,099 

870,348 

571,751 

3.964 

29 

1,586,309 

947,382 

638,927 

4.027 

30 

1,744,940 

1,132,120 

612,820 

3.511 

ment,  as  well  as  the  wasting  investment  in  plant  built 
with  reserves,  a  total  sum  of  approximately  $235,795.00. 
In  other  words,  the  cost  of  plant  built  with  the  reserve 
funds  exceeds  the  cost  of  the  original  plant  built  with 
stockholders'  money  by  approximately  $135,795.00.  The 


154  PUBLIC  UTILITIES 

plant  as  a  whole  still  has  a  depreciated  value  of  $100,- 
000.00,  as  there  has  been  invested  from  reserves 
approximately  $135,795.00  in  plant  which  has  itself  de- 
preciated about  $35,795.00  at  the  end  of  the  tenth  year, 
the  plant  representing  the  original  investment  has  become 
worn  out.  At  this  time  the  stockholders  must  invest 
$100,000.00  of  new  money  to  make  good  the  original  plant 
which  has  passed  out  of  existence  and  each  year  there- 
after money  must  be  paid  in  to  replace  portions  of  the 
plant,  originally  built  with  reserves,  which  become  yearly 
unserviceable.  At  the  beginning  of  the  nineteenth  year 
the  stockholders'  investment  has  become  about  $314,- 
359.00,  while  there  has  been  invested  in  plant  approxi- 
mately $555,992.00.  This  shows  that  at  this  particular 
time  the  reserves  for  renewals  are  $241,633.00,  approx- 
imately three-quarters  of  the  stockholders'  investment. 

This  study  illustrates  the  principle  of  the  operation  of 
depreciation  reserves  when  invested  in  plant  and  brings 
out  clearly  the  important  fact  that  very  large  reserves, 
under  certain  conditions,  are  essential  to  the  security  of 
the  investment  in  wasting  property. 

The  above  table  has  been  presented  in  an  extended 
form  in  order  to  illustrate  the  fact  already  suggested  in 
section  105,  that,  for  every  additional  investment  in  per- 
ishable property,  there  is  required  each  year  in  perpetuity 
a  sum  of  money  equal  to  a  certain  fraction  of  that  invest- 
ment to  be  set  aside  from  income  for  the  purpose  of 
renewals.  Clearly  the  same  results  can  be  obtained 
more  simply  by  making  a  reserve  each  year  equal  to  the 
cost-new  of  the  property  divided  by  the  life.  The  above 
table  is  useful  also  to  show  how  the  succeeding  table 
has  been  prepared,  wherein  it  is  shown  by  how  much 
greater  the  burden  is  upon  the  public  when  extensions  to 
plant  are  constructed  by  the  use  of  new  money,  subscribed 
by  the  stockholders,  than  is  the  case  when  the  money 


RESERVES  FOR  DEPRECIATION  155 

reserved  for  renewals  is  used  for  that  purpose.  It  must 
be  remembered  that,  to  make  this  comparison  possible, 
it  is  necessary  to  assume  that  all  of  the  reserves  invested" 
in  plant  were  for  needed  extensions  and  that,  if  the  reserves 
had  not  been  used  for  this  purpose,  money  would  have 
had  to  be  obtained  in  some  other  way.  Moreover,  it  can 
be  assumed  that  operating  expenses  and  taxes  are  propor- 
tional to  the  size  of  the  plant  and,  in  consequence,  need 
not  be  introduced  with  the  other  figures  presented  in  this 
study.  Reserves  for  renewals  must  be  first  taken  from 
gross  income  and  stockholders  can  obtain  8  per  cent  on 
the  money  invested  by  them  in  the  property. 

Table  IV,  page  156,  shows  the  gross  income  which  must 
be  obtained  from  the  public  when  the  reserves  are  in- 
vested in  plant  and  when  they  are  invested  in  outside 
securities. 

Column  3  shows  the  gross  income  required  when 
reserves  for  renewals  are  invested  in  plant,  and  column 
7  when  the  reserves  are  invested  in  outside  securities. 
It  will  be  seen  that,  although  somewhat  greater  in  the 
first  few  years,  in  later  years  the  amount  required  to 
be  paid  by  the  public  to  create  this  gross  income  is  con- 
siderably less  when  the  reserves  are  invested  in  needed 
extensions  of  plant  than  is  the  case  when  these  extensions 
are  paid  for  by  stockholders7  money  upon  which  the 
full  rate  of  return  must  be  paid. 

110.  Reserves  for  depreciation.  —  It  will  be  noted 
that  throughout  this  chapter  the  reserves  set  aside  each 
year  to  make  good  the  losses  in  the  capital  invested  in 
perishable  property  have  been  spoken  of  as  "reserves  for 
renewals."  This  term  is  not  that  usually  used.  These 
reserves  are  commonly  called  "reserves  for  depreciation." 
and  will  be  so  designated  hereafter  in  the  present  work. 
The  expression  " reserves  for  renewals"  has  been  used 
to  avoid  the  ambiguity  which  at  present  exists  in  the  use 


156 


PUBLIC  UTILITIES 


TABLE  IV 

GROSS  INCOME  REQUIRED  TO  PAY  RESERVES  FOR  RENEWALS  AND 
DIVIDENDS 

(Taxes  and  Operating  Expenses  Omitted) 


Reserves  for  Renewals 

Reserves  for  Renewals 

Invested  in  Plant 

Invested  in  Outside  Securities 

00 

Cost  of 

a 

t> 

Required 

"C*.2    £5 

a  * 

•8 

Plant 

S"c3  tnW 

| 

{I 

1 

"3 

it  If 

1 
"5 

1 

II 

3 

i 

loll 

5 

1 

(1) 

(2) 

(3) 

(4) 

(5) 

(6) 

(7) 

0  Year 

$100,000 

End  of  1st 

$10,000 

$8,000 

$18,000 

110,000 

$  8,724 

$  8,000 

$16,724 

2nd 

11,000 

8,000 

19,000 

121,000 

9,596 

8,800 

18,396 

3rd 

12,100 

8,000 

20,100 

133,100 

10,556 

9,680 

20,236 

4th 

13,310 

8,000 

21,310 

146,410 

11,612 

10,648 

22,260 

5th 

14,641 

8,000 

22,641 

161,051 

12,773 

11,713 

24,486 

6th 

16,105 

8,000 

24,105 

177,156 

14,050 

12,884 

26,934 

7th 

17,715 

8,000 

25,715 

194,872 

15,455 

14,172 

29,627 

8th 

19,486 

8,000 

27,486 

214,359 

17,001 

15,590 

32,591 

9th 

21,435 

8,000 

29,435 

235,795 

18,701 

17,149 

35,850 

10th 

23,579 

8,000 

31,579 

259,374 

20,571 

18,864 

39,435 

llth 

25,937 

8,800 

34,737 

285,311 

22,628 

20,750 

43,378 

12th 

28,531 

9,680 

38,211 

313,842 

24,890 

22,825 

47,715 

of  the  word  " depreciation/'  Reserves  thus  set  aside 
are  for  the  purpose  of  amortizing  the  loss  of  the  invest- 
ment in  property  of  limited  life.  As  far  as  reserves  for 
depreciation  are  concerned,  there  is  no  question  involved 
of  the  physical  condition  of  the  unit  at  any  intermediate 
date  in  its  well  defined  life.  A  unit  may  deteriorate  in  effi- 
ciency or  it  may  deteriorate  in  such  a  way  as  to  require 
greater  expenditures  for  maintenance,  but,  as  will  be 
shown  in  the  next  chapter,  such  "deterioration"  may 
affect  the  life  of  the  unit  but  can  affect  in  no  other  way 
the  reserves  for  renewals  which  must  equal  the  wearing 
value  of  that  unit  at  the  end  of  its  life  only. 


RESERVES  FOR  DEPRECIATION  157 

The  term,  "  reserves  for  renewals, "  conveys  this  impres- 
sion more  clearly  to  most  minds  than  "  reserves  for 
depreciation,"  for  two  reasons,  —  first,  depreciation 
to  be  figured  in  cases  of  valuation  for  a  date  interme- 
diate in  the  life  of  the  plant,  hence  there  is  always  a  ques- 
tion whether  or  not  reserves  for  depreciation,  i.e.,  reserves 
for  renewals  at  the  end  of  life,  are  a  measure  of  the  loss 
of  value  at  an  intermediate  date;  and,  second,  whether 
"  depreciation  "  and  "  deterioration  "  should  not  be  made 
synonymous  terms. 

These  two  questions  will  be  discussed  at  length  in  suc- 
ceeding chapters,  but  what  we  have  been  concerned  with 
up  to  the  present  time  has  been  the  " reserves"  required 
for  renewals,  usually  called  "  reserves  for  depreciation," 
which  reserves,  so  far  as  they  are  made  carefully  and  intel- 
ligently along  the  lines  which  have  been  suggested  above, 
have  nothing  to  do  with  deterioration  but  simply  insure 
the  undertaking  and  the  public  of  a  continuation  of  the 
operation  of  the  undertaking  with  best  service  at  the 
least  possible  expense. 


CHAPTER  X 

LIFE  OF  PLANT 

111.  Life  of  plant. 

112.  Continuation  of  undertaking. 

113.  Interest  of  public  in  operation  of  public  utility. 

114.  Interest  of  public  in  depreciation  reserves. 

115.  Maintenance  and  depreciation  reserves. 

116.  Importance  of  "life"  in  a  determination  of  depreciation. 

117.  Life  of  a  plant  unit. 

118.  Physical  life. 

119.  Factors  affecting  life  of  plant. 

120.  Inefficiency. 

121.  Wear  and  tear  of  plant. 

122.  Obsolescence. 

123.  Inadequacy  —  Definition. 

124.  Inadequacy  —  Changes  in  financial  policy. 

125.  Inadequacy  —  Engineering  economy. 

126.  Inadequacy  —  Unexpected  development. 

127.  Operation  of  factors  affecting  useful  life  of  plant  units. 

128.  Probable  life  of  various  plant  elements. 

129.  Limited  tenure  of  holding. 

111.  Life  of  plant.  —  Before  entering  upon  a  discus- 
sion of  the  loss  in  value  of  a  plant  on  account  of  age, 
which  is  the  problem  of  depreciation  in  a  valuation,  it 
will  be  necessary  to  consider  the  question  of  the  determina- 
tion of  the  life  of  each  unit  in  the  plant  as  well  as  the 
composite  life  of  the  plant  as  a  whole.  The  life  of  each 
unit  and  of  the  whole  plant  must  be  known  in  order  to 
make  proper  depreciation  reserves,  i.e.,  reserves  for 
renewals,  and  the  same  figure  is  needed  for  use  in  con- 
nection with  a  figure  showing  "age"  when  the  loss  of 
value  must  be  determined  in  an  appraisal. 

The  life  in  these  two  cases  should  be  the  same  but, 
clearly,  there  is  a  possibility  of  a  somewhat  greater  degree 
of  accuracy  when  life  is  determined  at  the  time  of  an 


LIFE  OF  PLANT  159 

appraisal,  for  the  reason  that  many  units  are  nearer  the 
ends  of  their  lives  so  that  a  shorter  forecast  into  the 
future  is  necessary. 

112.  Continuation  of  undertaking.  —  One  or  two  fun- 
damental considerations  must  be  appreciated  before  it 
is  possible  to  discuss  the  subject  of  the  life  of  a  plant  as 
it  must  be  determined  by  the  engineer.  The  first  and 
possibly  the  most  important  is  a  definite  recognition  of 
the  fact  that,  in  the  case  of  most  valuations,  an  appraisal 
is  made  of  a  continuing  service.  The  present  undertaking, 
or  possibly  its  successor,  will  continue  to  give  service  to 
the  public  for  many  years  in  the  future,  using  the  same 
plant  or  the  same  plant  renewed  when  portions  have 
become  unserviceable.  A  valuation  per  se  imposes  no 
limit  to  the  life  of  the  undertaking. 

At  first  sight  this  consideration  seems  to  be  unneces- 
sary but,  as  a  matter  of  fact,  the  lack  of  a  full  apprecia- 
tion of  this  point  has  been,  in  most  valuations,  the  source 
of  much  controversy.  There  is  a  tendency  for  all  men  to 
feel  that  apparatus  and  plant  which  has  been  for  some 
time  in  use  is " second-hand"  and  that,  being-second  hand, 
such  apparatus  and  plant,  even  though  it  may  have  been 
in  use  but  a  short  time,  must  be  of  greatly  reduced  value. 
Plant  units,  in  the  intermediate  years  of  their  lives,  would 
unquestionably  bring  much  lower  prices  if  they  had  to  be 
removed  from  the  plant  of  the  undertaking  and  sold. 
This  loss  in  value  would  arise  not  only  from  the  expense 
incident  to  their  removal  but  from  the  smaller  market 
which  exists  for  a  partly  worn  article.  But,  at  the  time 
of  an  appraisal  at  an  intermediate  time  in  the  life  of  most 
units,  there  is  no  question  but  that  the  units  will  be 
retained  in  the  plant  throughout  their  serviceable  life, 
whatever  that  life  may  have  been  determined  to  be. 
The  units  are  partially  worn  but  are  not  second-hand  in 
the  ordinary  acceptance  of  that  term.  This  is  equally 


160  PUBLIC  UTILITIES 

true  if  the  appraisal  is  made  for  a  case  of  sale.  The  pur- 
chaser is  buying  a  partially  worn  plant,  a  plant  which  he 
may  argue  is  second-hand,  but  it  is  an  assemblage  of 
units  furnishing  a  service  to  the  public  which  the  pur- 
chaser undertakes  to  continue  to  give.  Buyer  and  seller 
agree  upon  the  present  age  of  the  several  plant  elements 
as  well  as  upon  the  number  of  years  the  units  can  be 
retained  in  service,  i.e.,  the  life  less  the  age.  It  is  thus 
seen  that  there  have  been  removed  all  of  the  attributes 
usually  attaching  to  second-hand  plant  or  material.  The 
plant  units  are  to  be  retained  in  their  present  position 
until  the  end  of  an  agreed  period.  There  is  no  expense 
of  removal  or  adaptation  to  new  conditions,  and,  as  far 
as  may  be  humanly  possible,  all  uncertainty  as  to  the 
usefulness  of  second-hand  apparatus  has  been  removed 
by  the  agreement  of  experts  of  necessarily  differing  views 
as  to  the  length  of  time  it  is  wise  and  proper  to  retain 
the  units  of  the  plant  in  service. 

Thus  the  engineer's  problem  is  reduced  largely  to  a 
determination  of  the  years  of  remaining  serviceable  life 
in  the  several  units  of  which  the  plant  is  composed.  Usu- 
ally the  age  of  the  units  can  be  determined  without  diffi- 
culty or  controversy.  With  the  age  known  and  with  an 
agreement  as  to  the  years  of  remaining  life,  the  total  life 
of  each  unit  of  plant  has  been  found  and  the  engineer's 
portion  of  the  problem  of  determining  depreciation  has 
been  solved. 

113.  Interest  of  public  in  operation  of  public  utility.— 
A  second  consideration,  which  is  usually  lost  sight  of  in 
the  valuation  of  a  public  utility,  needs  to  be  fully  appre- 
ciated, and  that  is  that  a  public  service  undertaking 
has  been  given  certain  special  rights  and  privileges  and, 
in  return,  the  undertaking  must  conduct  its  business  in 
such  a  way  that  the  best  service  or  product  is  afforded 
with  the  least  expense  to  the  public.  It  is  the  question 


LIFE  OF  PLANT  161 

of  least  expense  to  the  public  which  requires  special  con- 
sideration in  this  connection. 

For  the  utility  furnished  by  the  public  service  under — 
taking,  the  public  must  pay  a  proper  rate  of  interest  upon 
the  invested  capital,  the  salaries  and  wages  properly 
attaching  to  the  operation  of  the  enterprise,  a  fair  and 
reasonable  profit  as  well  as  the  cost  of  current  mainte- 
nance and  repairs  and  proper  sums  to  be  set  aside  each 
year  to  defray  the  cost  of  the  replacement  of  the  plant  or 
portions  of  the  plant  when  they  can  be  retained  no  longer 
in  service.  The  first  three  of  the  above  sources  of  expense 
need  not  be  discussed  in  the  present  connection.  The 
last  two  items  of  expense,  current  maintenance  and 
repairs  and  depreciation,  are  the  two  directly  involved  in 
a  determination  of  the  depreciation  of  a  property. 

These  expenses  are  direct  contributions  made  by  the 
public  to  enable  the  undertaking  to  give  it  the  best  ser- 
vice not  only  at  the  present  time  but  in  the  future.  The 
rights  of  the  public  demand  that  the  sum  of  these  two 
items  should  be  kept  as  low  as  possible  consistent  with  a 
modern  and  high  grade  product.  The  demand  for  mak- 
ing the  sum  of  these  two  items  a  minimum  has  an  impor- 
tant influence  in  the  work  of  the  engineer  in  determining 
the  life  which  should  be  assigned  to  the  different  units  of 
plant. 

114.  Interest  of  public  in  depreciation  reserves.  —  As 
a  corollary  to  the  question  discussed  in  the  last  section  is 
the  fact  that  the  public  has  a  direct  interest  and  right  in 
the  reserves  which  are  contributed  by  them  for  the  special 
purpose  of  renewing  the  plant  when  it  becomes  unser- 
viceable and  are  held  by  the  undertaking  for  that  specific 
purpose.  It  will  be  found,  frequently,  that  officers  of 
undertakings  are  in  the  habit  of  considering  reserves  for 
depreciation  as  money  earned  through  their  own  good 
management  and,  as  such,  a  portion  of  the  property  of 


162  PUBLIC  UTILITIES 

the  undertaking.  Reserves,  thus  set  aside,  are  unques- 
tionably a  portion  of  the  property  of  the  undertaking, 
but  the  fact  must  not  be  lost  sight  of  that  the  money  thus 
set  aside  came  from  the  public  in  the  form  of  higher  rates 
than  would  have  been  required  otherwise,  and  that  the 
public  has  paid  such  higher  rates  for  the  sole  purpose  of 
guaranteeing  for  themselves  a  continuation  of  the  ser- 
vice of  the  utility  with  high  grade  apparatus  and  plant. 
The  reserve  fund,  therefore,  while  belonging  to  the  under- 
taking, belongs  also  to  the  public  which  actually  has  con- 
tributed it.  The  undertaking  must  hold  such  funds  for 
the  benefit  of  the  public  as  well  as  for  itself,  and  the 
reserves  for  depreciation  can  be  used  properly  and  legiti- 
mately only  for  one  purpose,  —  for  maintaining  the  value 
of  the  investment  in  perishable  property  unimpaired. 

The  truth  of  the  above  contention  has  become  so  well 
understood  and  established  that  it  would  be  unnecessary 
to  emphasize  it  in  this  connection  were  it  not  for  the  fact 
that  its  full  significance  has  not  been  appreciated  suffi- 
ciently by  the  officers  of  undertakings  or  by  experts. 
They  fully  recognize  that  the  reserves  for  depreciation 
should  not  be  distributed  as  dividends  to  the  stock- 
holders, but,  when  a  question  of  value  for  rates  or  for 
sale  arises,  they  are  in  doubt  as  to  the  proper  treatment  of 
this  fund  or  of  the  plant  which  may  have  been  acquired 
with  this  fund.  The  reserves  for  depreciation,  —  being, 
virtually,  funds  of  the  public,  held  in  escrow  for  plant 
renewals,  —  cannot  be  considered  as  a  part  of  the  prop- 
erty of  the  undertaking  upon  which  the  undertaking  can 
demand  a  return  nor,  in  the  case  of  a  sale,  can  such 
reserves  be  held  back  by  the  seller  as  his  property;  the 
reserves  must  be  transferred  to  the  buyer,  who  then 
becomes  responsible  to  the  public  for  the  proper  expend- 
iture of  such  reserves  in  replacing  plant  which  has  become 
unserviceable. 


LIFE  OF  PLANT  163 

115.  Maintenance    and     depreciation    reserves.  - 
There  is  another  feature  which  requires  definition  in  order 
that  the  subject  of  depreciation   may  be  fully  under- 
stood.    It  is  the  distinction  which  must  be  carefully 
made  between  the  cost  of  maintenance  and  the  cost  of 
renewals.    The  expenses  to  which  an  undertaking  is  put 
in  making  the  small  repairs  necessary  to  keep  a  plant  in 
a  high  state  of  efficiency  has  nothing  to  do  with  the 
depreciation  reserves.     It  is  a  current  expense  incident 
to  the  operation  of  the  plant  and  as  such  may  and  should 
be  taken  from  income.    The  cost  of  maintenance  for  each 
class  of  property  may  not  be  uniform  throughout  its 
life;    in  fact,  in  some  cases,  it  is  greatest  when  a  plant 
element  is  new  and,  in  a  large  proportion  of  cases,  it  is  of 
increasing  magnitude  for  each  year  of  increasing  age. 

This  question  of  cost  of  maintenance,  the  cost  of  keep- 
ing up  the  efficiency  of  a  plant  or  a  plant  element  may 
have  an  effect  upon  the  life  of  the  unit,  as  it  may  be  shown 
that  the  increased  cost  of  maintenance  would  justify 
the  renewal  of  the  unit,  but  it  can  thus  have  only  an 
indirect  effect  upon  the  depreciation. 

The  reserves  for  depreciation  are  designed  only  to 
keep  the  " capital"  of  the  undertaking  unimpaired,  and, 
as  a  consequence,  are  to  be  used  only  to  defray  that  por- 
tion of  the  expense  of  renewal  as  was  represented  by  the 
original  capital  cost  of  the  unit. 

116.  Importance  of  "life"  in  a  determination  of  depre-" 
ciation. — It  is  seen  from  the  above  considerations  that  the 
"life"  of  each  unit  of  plant  is  of  fundamental  importance 
in  a    determination    of    its   deterioration    or    deprecia- 
tion.    Its  life  may  depend  upon  a  number  of  considera- 
tions which  will  be  fully  discussed  later  but,  in  whatever 
manner  it  may  be  decided  eventually  that  a  plant  depre- 
ciates in  value  between  the  time  it  was  put  into  service 
and  the  time  of  its  renewal,  the  life,  the  years  of  useful 


164  PUBLIC  UTILITIES 

service,  is  the  same  and  is  the  one  and  most  important 
controlling  factor. 

117.  Life  of  a  plant  unit.  —  Some  clearness  in  the  pres- 
entation of  this  subject  can  be  obtained  by  making  a  dis- 
tinction between  the  actual  physical  life  of  the  unit  and 
its  serviceable  or  useful  life. 

The  physical  life  of  a  plant  unit  is  the  number  of  years 
that  it  could  be  retained  in  service  and  furnish  substan- 
tially the  same  character  of  service  as  it  was  designed  to 
afford. 

The  serviceable  or  useful  life  is  the  number  of  years 
during  which,  for  economic  or  public  considerations,  it 
may  be  considered  wise  to  retain  the  unit  in  service. 

In  very  many  cases  the  physical  life  and  the  useful 
life  may  be  the  same.  In  others,  the  useful  life  will  be 
less  than  the  physical  life. 

Clearly  in  no  case  will  the  useful  life  be  greater  than  the 
physical  life. 

118.  Physical  life.  —  The  physical  life  of  a  plant  unit 
is  the  number  of  years  that  the  unit  can  be  retained  safely 
Jin  service  without  introducing  any  hazard  to  the  uni- 
formity of  the  service  which  the  unit  is  called  upon  to 
perform.     Such  hazards,  as  may  occur,  arise  from  a  loss 
of  strength  in  the  unit  due  to  wear  and  tear  or  to  decay 
resulting  from  the  years  of  service.     Thus  the  strength 
of  a  pole,  used  to  support  overhead  wires,  diminishes 
as  time  goes  on  by  the  decay  of  the  wood,  of  which  the 
pole  may  be  made.    The  pole  has  a  physical  life  from  the 
time  it  was  set  up  to  the  day  when  the  pole  becomes  so 
weakened  by  decay  that  it  must  be  replaced  in  order  to 
remove  the  hazard  to  the  continuity  of  service  which 
arises  from  the  possibility  of  the  pole  falling  in  case  of  high 
wind  or  an  overload  of  snow  or  sleet.     Or  in  the  case  of 
an  electric  car  upon  a  tramway,  the  car  may  require 
occasional  repairs  but  the  physical  life  of  the  car  will 


LIFE  OF  PLANT  165 

be  the  length  of  time  that  it  can  be  retained  in  use 
and  furnish  good,  safe  and  satisfactory  service  to  the 
public. 

In  other  words,  the  physical  life  of  a  plant  unit  is  deter- 
mined largely  by  what  is  usually  spoken  of  as  the  "wear 
and  tear"  upon  the  unit  arising  from  its  position  and  the 
service  which  it  is  called  upon  to  perform. 

119.  Factors  affecting  life  of  plant.  —  The  years  of 
remaining  serviceable  or  useful  life  of  plant  elements 
must  be  determined  by  a  careful  consideration  of  all 
factors  or  conditions  which  may  tend  to  lengthen  or 
shorten  the  period  of  serviceability. 

The  following  factors  have  been  admitted  as  the  most 
important  to  be  considered  in  the  determination  of  this 
figure. 

1.  Wear  and  tear  of  plant. 

2.  Obsolescence. 

3.  Inadequacy. 

4.  Tenure  of  holding. 

120.  Inefficiency. —  Before  entering  upon  a  considera- 
tion of  the  above  factors  influencing  the  life  of  plant 
units,  it  will  be  well  to  discuss  somewhat  at  length  how 
far  the  value  of  a  plant  is  affected  by  the  relative  ineffi- 
ciency of  the  older  units  which  may  be  found  in  service 
as  compared  with  a  plant  composed  entirely  of  new  or 
newer  units.    This  question  is  introduced  thus  early  in 
the  consideration  of  depreciation  for  the  reason  that  the 
relative  inefficiency  of  an  older  plant,  as  compared  with 
a  newer,  is  one  of  the  most  frequent  arguments  raised  to 
substantiate  the  claim  in  a  valuation  that  the  existing 
plant,  being  more  or  less  inefficient,  is  really  second-hand 
and,  therefore,  of  an  abnormally  low  value.    Moreover, 
the  inefficiency  of  a  unit  may  arise  from  the  wear  and 
tear  of  use,  from  the  antiquation  of  the  method  of  its 
operation  as  compared  with  a  substitute  of  later  and 


166  PUBLIC  UTILITIES 

improved  design,  or  from  the  fact  that  the  business  has 
grown  to  such  an  extent  as  to  render  the  unit  too  small 
for  present  demands.  Thus  inefficiency  enters  as  a  fac- 
tor affecting  the  three  principal  factors,  to  be  discussed 
later,  which  have  a  dominating  influence  in  the  decision 
of  the  engineer  as  to  the  probable  life  of  the  unit. 

In  what  follows  it  will  be  shown  that  inefficiency  can- 
not be  made  a  factor  distinct  from  "wear  and  tear," 
"obsolesence,"  and  "  inadequacy,"  which  are  the  three 
main  causes  of  the  limits  imposed  upon  the  life  of  plant 
units,  but  rather  that  inefficiency  is  an  important  con- 
sideration or  factor  entering  into  the  determination  of 
the  life  period  assigned  from  a  study  of  these  three  main 
factors  affecting  the  "life"  of  perishable  property. 

It  must  be  recognized,  however,  that,  for  a  large  num- 
ber of  classes  of  units,  inefficiency  does  not  enter  at  all 
for  the  reason  that  the  units  of  such  classes  are  equally 
efficient  throughout  their  life.  Clearly  in  such  cases 
the  physical  life  is  limited  only  by  the  wear  and  tear 
which,  in  time,  renders  them  so  untrustworthy  as  to  intro- 
duce a  hazard  to  the  continuity  of  a  high  grade  of  ser- 
vice. Thus  in  the  case  of  poles,  wires,  conduits  and  many 
other  elements  of  a  similar  character,  there  is  no  diminu- 
tion in  the  efficiency  of  the  units  of  the  several  elements 
throughout  their  physical  life.  When  they  become  so 
weak  that  there  is  danger  of  their  failing  to  give  good 
service,  they  are  removed  and  replaced  by  new  units. 
But  during  their  entire  life  there  is  little  or  no  expense  of 
maintenance  incurred  to  keep  them  in  a  high  state  of  effi- 
ciency. Their  efficiency  remains  practically  uniform. 

But  with  other  classes  of  property,  especially  such  as 
have  moving  parts,  there  is  an  increasing  need  of  repairs 
with  increasing  life,  so  that  the  cost  of  maintenance 
becomes,  in  time,  a  matter  of  serious  importance  in  deter- 
mining the  useful  life  of  the  unit.  It  is  true  that,  by  con- 


LIFE  OF  PLANT  167 

stant  and  frequent  repairs,  the  useful  life  of  a  unit  might 
be  greatly  prolonged,  but  such  increased  useful  life  could 
be  obtained  only  by  an  excessive  cost  of  maintenance? 
As  this  cost  of  maintenance  is  a  charge  which  must  be 
borne  by  the  public,  no  public  service  undertaking  would 
have  performed  its  proper  duty  to  the  public  if  it  had 
not  seen  that  the  useful  life  of  each  plant  unit  was  made 
no  longer  than  could  be  justified  by  a  full  consideration 
of  the  economic  conditions  arising  from  the  cost  and 
annual  charges  of  a  new  unit  as  balanced  by  the  annual 
charges  arising  from  the  retention  of  an  older  unit  in 
service. 

The  same  is  true  in  the  case  of  such  elements  as  grad- 
ually become  less  efficient  and  must  be  subjected  to  fre- 
quent repairs  in  order  to  maintain  a  required  standard 
of  operation.  The  problem,  in  all  such  cases,  becomes  one 
of  determining  the  life  of  a  unit  by  a  consideration  of  cost 
and  annual  charge  upon  a  new  unit,  and  the  cost  of  main- 
tenance which  may  be  expected  to  arise  during  succeed- 
ing years  if  the  existing  unit  is  retained  in  service.  This 
problem  is  one  which  is  familiar  to  all  engineers  and  is 
still  one  of  determining  the  life  of  a  unit  but,  for  units  of 
this  class,  the  estimate  of  probable  life  is  not  based  upon 
general  knowledge  and  experience  as  to  the  usual  life  of 
units  of  the  same  character  under  similar  conditions 
but  upon  figures  gained  from  experience  as  to  costs  of 
new  units  and  the  annual  charges  upon  such  units  during 
succeeding  years  of  service. 

Again,  a  plant  unit  may  become  inefficient  as  compared 
with  a  new  form  of  later  design  or  in  which  some  new 
invention  has  been  incorporated.  In  such  a  case  the 
inefficiency  will  become  apparent  in  a  larger  cost  for  the 
production  of  the  service  sold  than  would  be  the  case  if 
the  newer  form  were  used.  The  problem  is,  again,  a 
simple  and  usual  one  for  the  engineer  to  solve,  having 


168  PUBLIC  UTILITIES 

due  regard  for  all  of  the  annual  charges  which  affect  the 
cost  of  the  service  to  the  public.  In  this  case  the  engineer 
must  determine  when  the  renewal  should  be  made  and 
produce  a  minimum  charge  over  a  term  of  years  for  inter- 
est on  the  investment,  depreciation  reserves,  mainte- 
nance and  cost  of  operation.  If  the  figures  representing 
these  annual  charges  have  been  determined  with  care, 
the  life  to  be  given  to  the  unit  can  be  readily  assigned. 

Again,  a  plant  unit  which  has  become  too  small  may 
have  its  life  determined  largely  by  engineering  reasoning 
based  upon  the  above  items  of  annual  expense  which 
must  be  borne  by  the  public. 

It  is  thus  seen  that  inefficiency  is  a  result  produced 
in  many  cases  by  the  "wear  and  tear,"  " obsolescence," 
or  " inadequacy"  of  the  plant  unit.  It  is  the  measure 
usually  of  the  limit  imposed  upon  the  life  of  the  units 
by  each  one  of  the  above  three  factors.  It  cannot  be 
considered  in  any  way  as  an  independent  factor  pro- 
ducing depreciation  nor,  in  the  usual  interpretation  of  its 
effect,  of  transforming  existing  plant  into  second-hand 
plant  even  though  such  plant  is  retained  in  service.  Ineffi- 
ciency may  be  the  final  factor  imposing  the  limit  to  be 
assigned  to  the  life  of  a  unit  under  each  one  of  the 
factors,  "wear  and  tear,"  "obsolescence"  and  "inade- 
quacy," but  one  of  these  three  factors  alone  is  instru- 
mental in  determining  the  life  of  a  unit  and,  when  that 
life  has  been  determined  and  assigned  definitely,  and  not 
until  after  that  life  has  been  exhausted,  does  the  plant 
become  second-hand. 

121.  Wear  and  tear  of  plant.  —  As  has  been  stated 
already  in  speaking  of  physical  depreciation,  the  first  and 
usually  the  most  important  factor  tending  to  limit  the 
life  of  a  plant  unit  of  an  undertaking  is  that  which  arises 
simply  from  time  of  service,  exposure  to  the  elements  and 
decay,  and  has  been  termed  "wear  and  tear." 


LIFE  OF  PLANT  169 

All  elements  and  units  in  a  plant  begin  to  deteriorate 
with  more  or  less  rapidity  from  the  moment  they  are  intro- 
duced into  the  plant,  even  though,  in  many  cases,  the- 
actual  use  of  the  units  may  not  be  great.  Thus,  poles, 
insulation  of  outside  rubber-covered  wire,  switchboard 
plugs  and  cords  all  begin  to  deteriorate  with  more  or  less 
rapidity  from  the  time  they  are  put  into  place,  and  will 
continue  to  deteriorate  until  such  time  as  the  units  are 
unable  to  meet  the  requirements  of  service  and  must  be 
replaced. 

Deterioration  as  here  considered  has  no  effect  upon  the 
service  or  utility  furnished,  as  the  plant  is  kept  up  to  a 
standard  of  operating  efficiency  by  the  repair  of  individ- 
ual units  and  by  the  time  and  money  expended  for  the 
up-keep  of  the  plant,  usually  termed  the  "  maintenance 
and  current  repair"  of  the  plant.  But  despite  such 
maintenance  and  current  repair,  a  time  comes  when  either 
the  expenses  of  this  character  become  so  great  that,  for 
engineering  and  coinmercial  reasons,  the  unit  of  plant 
has  to  be  replaced,  or  the  unit  becomes  so  weak  as  to  ren- 
der  its  retention  a  hazard  to  the  service  and  makes*  its 
replacement  desirable. 

It  must  be  clearly  remembered  that  the  above  figures 
for  the  life  of  elements  will  be  greatly  affected  by  the 
condition  in  which  they  have  been  maintained  by  current 
repair.  In  consequence  of  this,  the  effects  of  wear  and 
tear  upon  the  elements,  of  which  the  plant  is  composed, 
cannot  be  determined  by  theoretical  considerations  but 
only  by  actual  observation  and  inspection  made  by  ex- 
perts familiar  with  the  operation  of  similar  plants. 

122.  Obsolescence.  —  The  physical  life  of  a  unit  of 
plant  may  be  shortened  by  changes  or  improvements  in 
the  art,  which  development  will  be  productive  of  a  better 
product  or  of  a  similar  product  at  a  lower  cost,  or  pos- 
sibly of  both. 


170  PUBLIC   UTILITIES 

A  public  service  undertaking  is  bound,  in  virtue  of  the 
franchises  it  has  received,  to  give  to  the  public  the  best 
service  that  can  be  offered  and  at  as  low  a  cost  as  may 
be  consistent  with  the  public  needs.  The  development  of 
the  art,  upon  which  most  utilities  are  dependent,  has  been 
gradual  in  the  past  and  it  is  probable  to  continue  into 
the  future.  Under  such  conditions  it  is  frequently 
necessary  to  replace  an  existing  unit  before  the  number  of 
years,  assigned  to  it  on  the  basis  of  its  physical  life,  has 
been  attained. 

Thus  there  are  two  considerations  involved  in  obsoles- 
cence, —  improved  character  of  service  fl/n rl  inf^rpg^pH 
efficiency.  Both  of  these  considerations  must  be  ever 
in  the  mind  of  the  engineer  when  making  his  estimate  as 
to  how  far  this  factor  of  obsolescence  may  enter  to  affect 
the  life  of  any  plant  unit. 

Unquestionably  there  will  be  always  some  uncertainty 
attaching  to  the  estimate  made  by  the  engineer  as  to  the 
limit  of  the  life  of  a  unit  to  be  expected  by  the  oper- 
ation of  the  factor  of  obsolescence.  Moreover,  there  can 
be  no  question  but  that  the  accuracy  of  the  forecast  will 
depend  very  largely  upon  the  familiarity  of  the  engineer 
not  only  with  the  developments,  which  have  taken  place 
in  the  past  in  the  special  art  involved,  but  with  the  weak- 
nesses of  the  present  plant  equipment  and  the  probability 
of  such  defects  being  overcome  within  the  physical  life  of 
each  unit  by  improvements  and  inventions.  But  these 
uncertainties  should  cast  no  doubt  upon  the  importancex 
of  a  careful  and  expert  forecast  of  the  effects  of  obsoles- 
cence upon  the  lives  of  the  several  plant  units.  It  can- 
not be  denied  that  obsolescence,  in  the  past,  has  entered 
in  a  very  large  number  of  cases  to  limit  the  serviceable 
life  of  many  units  of  plant  and  there  is  no  reason  to 
suppose  that  similar  conditions  may  not  arise  in  the 
future.  No  undertaking  would  be  wise  in  assuming  that 


LIFE   OF  PLANT  171 

all  of  the  plant  could  be  retained  in  service  until  it  had 
been  worn  out  completely.  However,  with  each  succeed- 
ing year  of  the  life  of  the  unit,  this  uncertainty  becomes 
less,  so  that,  in  most  cases,  at  the  time  of  an  appraisal, 
usually  some  years  after  the  plant  units  have  been  in 
service,  there  is  sufficient  information  at  hand  to  be  able 
to  tell  with  reasonable  accuracy  whether  or  not  the  limit 
of  life  due  to  obsolescence  will  be  less  than  the  physical 
life  and  to  assign  some  definite  figure  with  this  considera- 
tion in  mind. 

In  the  case  of  most  public  utilities,  the  problem  of  obso- 
lescence is  not  as  difficult  of  solution  as  it  may  seem  to 
those  who  are  not  specially  expert  in  the  art.  With  by 
far  the  larger  number  of  classes  of  units,  those  most  famil- 
iar with  the  art  know  the  units  which  will  be  able  to 
serve  their  entire  physical  life,  and  what  classes  are  so 
uneconomical  or  otherwise  defective  that  some  improve- 
ment must  be  expected.  But,  even  for  this  latter  class, 
there  is  always  the  question  of  the  economical  time  when 
the  change  should  be  made  and  still  further  there  is  the 
probability,  especially  with  the  larger  utility  undertak- 
ings, of  some  time  elapsing  before  it  is  wise  or  possible  to 
make  a  replacement  of  all  units  of  the  plant.  It  is  not 
usual  that  such  changes  can  be  made  in  a  wholesale 
manner.  Thus,  taking  the  case  of  a  telephone  switch- 
board, a  new  form  may  be  developed  to-day  but  it 
would  require  many  years  before  a  general  change  could 
be  made  of  all  switchboards  in  the  system.  Changes  of 
this  character  must  be  made  slowly  and  carefully  in  order 
that  no  interference  with  the  service  should  take  place 
and,  in  any  wise  replacement  of  older  switchboards  by 
newer  forms,  it  is  probable  that  obsolescence  would  have 
only  a  small  effect  as  a  limitation  upon  the  physical  life 
of  apparatus  of  this  character. 

123.  Inadequacy.    Definition.  —  A  third  factor  tend- 


172  PUBLIC  UTILITIES 

ing  to  shorten  the  lives  of  plant  units  is  "  inadequacy/ ' 
which,  as  the  term  implies,  is  the  condition  arising  from 
the  growth  of  the  business  and  from  the  consequent  neces- 
sity of  replacing  smaller  units  by  larger  ones. 

While  this  factor  is  unquestionably  one  which  has  been 
the  reason  for  shortening  the  lives  of  many  units,  par- 
ticularly in  communities  where  the  increase  in  activities 
has  been  rapid,  and  although  it  has  been  recognized  by 
the  courts  as  one  of  the  factors  which  should  be  consid- 
ered in  determining  the  probable  lives  of  plant  units,  yet 
in  some  respects  it  seems  to  be  somewhat  different  in 
character  from  either  "wear  and  tear"  or  " obsolescence." 

There  appear  to  be  three  main  classes  of  conditions 
which  tend  to  introduce  this  factor  of  inadequacy,  - 
first,  a  change  in  financial  policy;    second,  engineering 
jgonomy:   and  thirb!.  unexpected  development. 

124.  Inadequacy.  Changes  in  financial  policy.  - 
That  changes  in  financial  policy  have  been  the  cause  of 
the  rejection  of  many  plant  units  as  too  small,  will  be 
apparent  if  the  past  history  of  many  of  our  public  utility 
undertakings  is  reviewed  with  this  thought  in  mind.  It 
will  be  surprising  to  note  in  what  a  la^ge  proportion  of  the 
cases  where  units  have  been  replaced  for  the  reason  that 
they  were  of  inadequate  size,  the  cause  can  be  attributed 
directly  to  a  lowering  of  the  rates  for  service  or  to  the 
introduction  of  some  special  rates  to  attract  new  classes 
of  customers.  It  is  here  contended  that  inadequacy 
based  on  such  a  reason  is  not  the  inadequacy  recognized 
by  the  courts  as  justification  for  the  assignment  of  a 
shorter  life  to  units  and  the  consequent  imposition  of 
larger  reserves  to  be  contributed  by  the  earlier  subscribers 
to  the  service  afforded  by  the  utility.  The  burden, 
which  such  a  change  in  policy  necessarily  imposes,  should 
be  borne  largely,  if  not  wholly,  by  those  who  are  to  be 
benefited  directly  by  the  change.  Thus,  if  a  gas  company, 


LIFE  OF  PLANT  173 

with  mains  of  sufficient  size  for  the  usual  supply  of  gas, 
should  offer  new  and  lower  rates  for  some  particular 
purpose  which  necessitated  the  replacement  of  the  half 
worn  existing  mains  by  larger  ones,  the  inadequacy  thus 
produced  and  the  decreased  life  of  the  older  mains  is  not 
a  legitimate  limit  to  be  imposed  by  inadequacy  to  the  life 
of  the  original  mains.  It  is,  on  the  contrary,  a  special 
case,  in  which  the  loss  in  the  otherwise  remaining  value 
in  the  original  mains  forms  a  portion  of  the  cost  incident 
to  the  new  service,  the  rates  for  which  should  be  made 
sufficiently  high  to  amortize  this  loss. 

This  feature  of  inadequacy  becomes  of  special  impor- 
tance in  cases  of  the  sale  of  the  property  of  public  utility 
undertakings.  The  buyer  may  have  in  mind  to  take  ad- 
vantage of  conditions  not  available  to  the  original  owner 
or  to  form  a  combination  with  some  other  similar  enter- 
prise. The  buyer,  in  such  cases,  would  contend  that  many 
of  the  units  in  the  plant  which  he  wishes  to  acquire  are  of 
inadequate  size  for  his  new  purposes  and,  as  a  consequence, 
should  be  considered  as  having  completed  their  years  of 
serviceable  life.  The  seller,  on  the  contrary,  would  con- 
tend that  the  units  were  adequate  for  the  successful  op- 
eration of  the  plant  on  the  lines  originally  contemplated 
for  a  number  of  years  to  come  and,  therefore,  could  not 
be  considered  as  unserviceable.  These  two  contentions 
would  be  reasonable  and  logical  were  the  present  value  to 
be  determined  for  the  property  of  a  private  undertaking. 
An  owner  of  a  private  undertaking  may  endeavor,  as 
far  as  may  be  possible,  to  write  down  the  value  of  his 
plant,  through  large  reserves  for  depreciation,  so  that  at 
all  times  the  existing  value  may  be  what  could  be  obtained 
for  the  plant  primarily  as  scrap,  should  he  be  forced  to 
sell.  But  the  case  is  entirely  different  when  the  value 
of  the  property  of  a  public  utility  is  involved.  The  con- 
ditions are  entirely  altered  by  the  fact  that  the  interests 


174  PUBLIC  UTILITIES 

of  the  public  are  involved.  Thus,  in  the  sale  of  a  public 
utility,  there  are  the  interests  of  three  parties  at  stake,  - 
the  buyer,  the  seller  and  the  public.  If  the  officers  of  a 
public  utility  undertaking  had  reason  to  expect  even  a 
remote  probability  that  their  property  might  be  taken 
by  condemnation  and  that  it  might  be  considered  as 
inadequate  due  to  a  change  in  conditions  beyond  their 
control,  clearly  it  would  be  their  duty  to  make  "  inade- 
quacy" a  controlling  factor  in  shortening  the  life  of  the 
plant  and  by  so  doing  oblige  the  public  to  pay  such  higher 
rates  as  would  amortize,  through  the  annual  reserves  for 
depreciation,  the  entire  cost  of  their  plant  within  the 
years  that  the  plant  -remained  under  their  control.  But 
such  a  condition  should  not  arise.  A  public  utility  under- 
taking has  obtained  special  rights  and  in  return  it  must 
give  to  the  public  the  best  service  with  a  minimum  total 
cost  to  the  public  for  such  service.  When  such  an  under- 
taking has  performed  its  duty  faithfully,  the  public  is 
bound  to  respect  the  fact  that  the  undertaking  has  in- 
curred certain  hazards  and  risks  for  its  benefit  in  extending 
the  number  of  years  of  useful  life  as  far  as  was  safe  in 
order  that  the  cost  of  the  service  to  the  public  might  be 
made  as  low  as  possible. 

In  a  case  of  sale,  therefore,  if  it  can  be  shown  that 
inadequacy  as  of  the  date  of  transfer  could  not  have 
been  proved,  if  the  original  undertaking  had  been  per- 
mitted to  continue  along  the  lines  of  development  origi- 
nally wisely  and  properly  planned,  the  change  in  policy 
contemplated  by  the  buyer  cannot  be  given  as  a  reason 
for  a  reduction  in  useful  life  due  to  inadequacy.  The 
buyer  must  pay  the  value  which  still  exists  in  each  unit, 
arising  from  the  years  of  serviceable  life  which  each  unit 
would  possess  had  no  change  in  policy  or  management 
arisen.  Should  the  buyer,  having  paid  more  than  scrap 
value  for  units  which  he  deems  inadequate  for  his  new 


LIFE  OF  PLANT  175 

purpose,  decide  that  a  change  is  desirable,  the  burden  is 
upon  him  to  show  that  the  cost  of  new  units  plus  the 
price  paid  for  existing  units,  when  properly  combined  with 
the  annual  charges,  would  result  in  such  economies  that 
the  cost  of  service  to  the  public  would  be  reduced. 

The  above  consideration  is  most  important,  as,  on  any 
other  basis,  the  public  might  be  very  heavily  burdened. 
Public  utilities,  on  the  one  hand,  must  be  given  such  a 
guarantee  of  a  continuity  of  service  or  of  such  fair  treat- 
ment, in  case  of  condemnation  or  sale,  that  nothing  abnor- 
mal in  amount  can  be  added  as  a  burden  upon  the  public 
in  the  way  of  needlessly  high  rates  arising  from  the  neces- 
sity of  making  large  reserves  for  depreciation.  On  the 
other  hand,  nothing  should  be  done  to  prevent  the  pub- 
lic from  obtaining  the  advantages  which  may  result  from 
economies  due  to  combinations  or  enlargements  of  the 
undertakings  furnishing  the  service. 

Thus,  if  it  can  be  shown  that  the  public  can  obtain 
the  highest  grade  of  service  at  less  cost  by  the  combina- 
tion of  two  competing  undertakings  furnishing  the  same 
or  similar  service  within  the  same  territory,  no  impedi- 
ment should  be  introduced  which  would  deprive  the  pub- 
lic of  such  saving.  If,  in  such  a  combination,  it  is  ruled 
that  such  of  the  acquired  plant,  as  is  too  small  for  the 
enlarged  undertaking,  has  only  value  as  scrap,  then  a 
legitimate  objection  can  be  made  by  the  seller  on  the 
ground  that  he  is  deprived  of  property  which,  to  the 
public  and  to  the  company  which  he  represents,  has 
more  than  scrap  value.  On  the  other  hand,  if  a  fair  pres- 
ent value  is  given  for  such  units,  the  public  should  be 
willing  to  give  up  a  portion  of  the  savings,  which  such 
a  combination  would  afford,  by  contributing  somewhat 
larger  sums  to  the  annual  reserves  in  order  to  provide 
funds  to  amortize  the  assigned  present  value  of  plant 
which  would  not  be  used  for  as  long  a  period  of  time  as 


176  PUBLIC  UTILITIES 

might  have  been  possible  had  the  combination  not  taken 
place. 

125.  Inadequacy.    Engineering  economy.  —  This  con- 
dition of  inadequacy  arises  from  the  fact  that  in  many 
instances  a  new  undertaking  cannot  construct,   at  the 
outset,  a  plant  of  sufficient  size  to  meet  the  requirements 
of  the  business  throughout  the  physical  life  of  all  of  its 
plant  units.     The  engineer  figures  for  how  long  a  time  in 
the  future  it  is  safe  to  plan  and  places  units  of  such  size 
as  will  produce  a  maximum  of  economy  when  to  such  cost 
is  added  the  loss  incurred  in  the  shortened  life  of  an  inade- 
quate but  otherwise  serviceable  unit. 

It  is  inadequacy  of  this  kind  that  can  be  made  properly 
one  of  the  factors  tending  to  limit  the  life  of  units  of 
plant.  The  engineer  has  had  the  interests  of  the  public 
in  mind  in  that  he  has  constructed  a  plant  of  only  such 
size  as  will  produce  a  minimum  of  cost  in  annual  charges 
and  in  operation.  When  the  development  of  the  business 
will  warrant  units  of  increased  size,  they  can  be  obtained, 
but  until  that  time  arrives  the  greatest  economy  is  found 
by  the  use  of  smaller  units  of  smaller  first  cost. 

The  problem  for  the  engineer  in  this  case  is  that  dis- 
cussed under  the  head  of  " Inefficiency"  in  section  120. 

126.  Inadequacy.    Unexpected  development.  —  It  not 
infrequently  happens,   especially  in  the  more  recently 
settled  portions  of  this   country,   that   the   community 
grows  more  rapidly  than  could  have  been  expected  at 
the  time  of  the  original  design  of  the  plant.     Or  again, 
when  the  undertaking  is  furnishing  a  new  and  little  known 
utility,  the  demands  of  the  public  exceed  the  reasonable 
expectations  of  the  management  responsible  for  the  origi- 
nal design  of  the  plant.     This  condition  of  unexpected 
development,  either  of  the  population  or  of  demands  for 
the  service  offered,  is  a  second  legitimate  reason  for  a 
careful  estimate  of  the  probable  life  of  the  plant  units. 


LIFE  OF  PLANT  177 

In  growing  communities  or  with  an  unknown  service,  it 
is  proper  and  wise  to  place  a  lower  estimate  for  the  life 
of  certain  plant  units  as  far  as  inadequacy  is  concerned 
than  would  be  the  case  under  more  stable  and  better 
known  conditions. 

127.  Operation  of  factors  affecting  useful  life  of 
plant  units.  —  It  is  apparent  that  these  three  factors, 
as  they  have  been  called,  wear  and  tear,  obsolescence 
and  inadequacy,  are  not,  properly  speaking,  factors, 
but  are  conditions  affecting  the  life  of  a  unit  of  plant 
and,  incidentally,  its  scrap  or  salvage  value.  Time  enters 
in  each  of  these  three  factors  and  what  is  needed  is  a 
knowledge  of  the  probable  useful  life  of  the  plant  units 
looked  at  from  these  three  points  of  view.  The  question 
is  simply,  how  long  can  the  special  plant  unit  under  consid- 
eration remain  in  service.  If  the  unit  will  become  inad- 
equate in  ten  years,  the  fact  that  it  is  only  half  worn  out 
and  is  of  the  latest  design  has  no  weight  whatever  as 
affecting  that  life.  It  will  enhance  the  scrap  value  of 
the  unit,  and  that  is  all.  It  is  that  factor  or  condition 
which  produces  the  shortest  life  that  is  of  determining 
importance.  One  or  the  other  of  these  factors  or  con- 
ditions must  be  controlling  in  a  determination  of  the 
probable  serviceable  life  of  a  plant  unit.  In  a  deter- 
mination of  the  scrap  or  salvage  value  of  a  unit,  all  three 
considerations  become  of  greater  or  less  importance,  de- 
pending upon  the  probable  serviceable  life  assigned  to  the 
unit  looked  at  from  these  three  points  of  view.  Thus, 
if  it  is  estimated  that  the  unit  is  entirely  worn  out  at  the 
end  of  ten  years,  that  it  would  be  probably  obsolete  in 
fifteen  years,  and  inadequate  in  twelve,  clearly  the  scrap 
value  would  be  small.  But  if  it  was  estimated  that  it 
would  become  inadequate  in  ten  years,  worn  out  in 
twelve  years  and  obsolete  in  fifteen  years,  then  the  scrap 
value  would  be  of  some  importance. 


178  PUBLIC  UTILITIES 

128.  Probable  life  of  various  plant  elements.  —  Much 
of  the  misunderstanding  which  has  existed  relative  to 
the  subject  of  depreciation  has  been  due  to  a  failure  to 
appreciate  the  distinction  which  must  be  made  as  to  which 
of  the  factors  is  controlling  in  deciding  what  may  be  the 
probable  serviceable  life  of  plant  units.  The  period, 
during  which  the  amortization  of  the  capital  invested  in 
perishable  property  must  take  place,  can  be  found  only 
by  a  determination  of  which  one  of  the  three  factors, 
"wear  and  tear,"  " obsolescence "  or  "inadequacy," 
imposes  the  limit  as  to  the  useful  life  of  the  plant 
units. 

A  few  examples  will  be  given  to  illustrate  the  method 
which  must  be  employed  in  determining  the  useful  life 
of  plant  units. 

In  a  case  of  poles  used  for  cross-country  telegraph  or 
telephone  lines,  it  may  be  found  that  the  probabilities 
are  that  the  poles  will  always  be  adequate,  arid  that  the 
factor  of  obsolescence  will  not  enter  during  the  period 
in  which  the  strength  of  the  pole  will  remain  sufficient  to 
perform  the  work  for  which  it  was  intended.  In  such  a 
case,  the  factor  of  wear  and  tear  only  enters,  and  it  is 
possible,  if  the  sizes  of  the  poles  and  the  kinds  of  material 
of  which  the  poles  are  made,  are  known,  for  one,  who  has 
had  experience  with  such  a  class  of  construction,  to  fore- 
cast the  probable  number  of  years  of  serviceable  life  of 
the  poles  with  much  accuracy.  The  salvage  value  of 
a  pole  at  the  end  of  its  serviceable  life  can  be  deter- 
mined also  with  reasonable  accuracy. 

If  the  case  is  taken  of  an  aerial  telephone  cable,  it  is 
known  that  its  life  is  practically  indeterminate  as  long  as 
it  remains  in  its  original  position  in  the  plant,  as  there 
is  no  known  effect  of  wear  and  tear  upon  it.  As  a  prac- 
tical matter  there  is  no  present  indication  of  a  change 
to  a  more  efficient  design,  thereby  eliminating  any  prob- 


LIFE  OF  PLANT  179 

able  question  as  to  obsolescence.  There  remains  only 
the  factor  of  inadequacy  to  be  considered.  It  is  known 
that  most,  if  not  all,  removals  of  aerial  telephone  cables- 
in  the  past  twenty  years  have  been  made  for  the  reason 
that  there  has  been  such  a  growth  in  lines  that  cables  of 
larger  size  have  been  demanded,  or  that  the  aerial  cables 
in  some  localities  have  had  to  be  superseded  by  under- 
ground cables.  The  life  of  an  aerial  cable  becomes,  there- 
fore, largely  a  consideration  of  local  conditions,  and  a 
forecast  must  be  made  by  one  most  familiar  with  the 
present  and  future  conditions  of  the  business  in  that 
locality,  to  determine  the  length  of  time  the  cable  may  be 
retained  in  its  original  position.  The  salvage  value  will 
be  the  original  cost  of  the  cable,  less  the  cost  of  taking  it 
down,  transporting  it  to  the  storehouse,  interest  during 
the  time  which  it  will  probably  be  out  of  service,  and 
possibly  an  allowance  for  the  cost  of  some  injury  which 
may  occur  during  the  act  of  removal.  In  this  case  the 
salvage  value  will  be  relatively  large. 

Many  engineers  have  used  and  commissions  have 
adopted  years  of  serviceable  life  and  salvage  values  for 
the  many  plant  elements  of  public  utilities,  as  definite 
figures  suitable  for  use  in  valuations  of  similar  elements 
in  all  plants  and  have  made  no  record  whatever  as  to  the 
consideration  which  has  led  to  the  adoption  of  such  fig- 
ures. Moreover,  these  figures  have  been  quoted,  gener- 
ally, as  those  equally  applicable  to  a  determination  of 
" depreciation"  and  " depreciation  reserves."  Practi- 
cally all  published  figures  of  this  kind  are  open  to  this 
objection,  but  naturally  some  are  more  objectionable  than 
others.  Thus,  the  published  figures  as  to  the  serviceable 
life  of  a  certain  size  and  kind  of  pole  would  be,  in  all  prob- 
ability, capable  of  acceptance  without  criticism,  as 
there  is  but  one  factor,  wear  and  tear,  which  is  domi- 
nant in  determining  its  serviceable  life,  and  experi- 


180  PUBLIC  UTILITIES 

ence  has  been  sufficient  to  show  the  probable  number 
of  years  that  it  can  remain  in  service.  But,  figures 
that  have  been  published  as  to  the  life  of  a  telephone 
switchboard,  for  example,  are  worthless  as  they  now 
stand.  If  wear  and  tear  alone  were  considered,  the 
probable  life  of  a  telephone  switchboard,  as  properly 
and  usually  maintained,  would  be  twenty  to  thirty 
years.  Most  competent  telephone  experts  would  agree 
in  such  a  figure.  Nevertheless,  a  life  of  seven  or  twelve 
years  l  has  been  frequently  given,  showing  that  experts 
have  taken  inadequacy  or  obsolescence  as  the  controlling 
factor  in  limiting  the  serviceable  life  of  the  switchboard. 
In  view  of  the  absence  of  definite  information  as  to  what 
was  the  controlling  factor  in  arriving  at  the  figures,  in- 
tended to  show  the  years  of  useful  life  of  plant  elements 
and  their  salvage  values,  found  in  papers  and  reports  on 
this  subject,  such  figures  for  a  new  and  special  case  must 
be  considered  as  of  little  or  no  value. 

129.  Limited  tenure  of  holding.  —  An  undertaking, 
which  has  a  limited  franchise  or  right  given  it  to  operate, 
may  have  no  agreement  as  to  the  disposition  of  its  plant 
nor  of  its  business  at  the  end  of  its  tenure  of  holding. 
Those  who  have  invested  their  money  in  the  undertak- 
ing will  expect  to  obtain  not  only  a  proper  yearly  return 
upon  their  investment  during  the  period  that  the  busi- 
ness is  in  operation  but  to  recover  the  principal  invested 
in  the  undertaking  at  the  expiration  of  the  franchise. 

Such  cases  in  this  country  are  probably  extremely 
rare.  In  such  a  case  as  there  is  a  limited  tenure  of  hold- 
ing, the  life  of  the  property  as  a  whole  is  defined  and  the 
number  of  years  specified  must  be  considered  with  those 
above  described  in  determining  the  basis  for  amortization 
of  the  cost  of  property. 

1  See  Wis.  R.  R.  Com.  Rpts.,  Vol.  IV,  p.  9. 

Also  Institution  of  Post  Office  Engineers,  April  4,  1910. 


LIFE  OF  PLANT  181 

As  a  factor  affecting  the  depreciated  value  of  a  plant, 
cases  of  limited  tenure  of  holding  are  too  rare  to  give  it 
further  consideration.  When  such  a  condition  is  pre- 
sented, there  will  be  found,  usually,  some  agreement  as 
to  the  disposition  of  the  plant  and  the  business,  so  that 
this  factor,  being  a  rare  and  special  one,  must  be  consid- 
ered on  the  merits  of  each  particular  case  as  it  arises. 


CHAPTER  XI 

DEPRECIATION 

130.  Definition. 

131.  Physical  condition  not  a  direct  measure  of  loss  of  value. 

132.  Determination  of  age. 

133.  Mean  "life"  and  mean  "age." 

134.  Determination  of  loss  of  value  a  problem  in  accountancy. 

135.  Shall  loss  in  value  due  to  age  be  figured  by  straight  line  or  sinking 

fund  method? 

136.  Return  to  undertaking  based  upon  fair  value  of  property. 

137.  Loss  in  value  of  plant  arising  from  age. 

138.  Loss  in  value  of  property  consisting  of  plant  and  reserves. 

139.  Justice  of  the  rule  as  to  use  of  straight  line  or  sinking  fund  method. 

140.  "Pseudo"  mean  age. 

141.  Loss  in  value  of  property  when  all  reserves  have  been  held  invested 

in  outside  securities. 

142.  Loss  in  value  of  property  consisting  of    plant,  built  partly  with 

reserves,  and  of  reserves. 

143.  General  consideration  of  loss  in  value  due  to  age. 

144.  Question  as  to  necessity  of  reserves  sufficient  to  maintain  value  of 

original  investment. 

/  130.  Definition.  —  Depreciation  may  be  defined  as 
/  "the  loss,  arising  from  years  of  service,  in  the  value  of  the 
^  investment  in  perishable  property." 

Depreciation  is  a  measure  of  the  loss  in  value  of  the  in- 
vestment in  perishable  property  arising  from  the  time  that 
such  property  has  been  in  service,  as  related  to  the  total 
number  of  years  of  serviceability.  It  is  possible  to  ascer- 
tain with  a  fair  degree  of  accuracy  the  time  that  each 
unit  of  the  plant  has  been  in  service,  that  is  to  say  its 
"age,"  and  for  experts  to  predict  with  more  or  less  cer- 
tainty the  length  of  time  that  each  unit  can  be  expected 
to  be  retained  in  service.  The  sum  of  this  last  figure 
and  the  age  gives  the.  serviceable  "life"  of  the  unit. 
Each  unit  of  plant,  therefore,  at  the  time  of  an  appraisal 


DEPRECIATION  183 

can  be  figured  as  having  a  certain  number  of  years  of 
remaining  usefulness  out  of  a  total  life  of  an  estimated 
number  of  years.  At  the  end  of  the  period  of  service- 
ability of  a  unit,  there  will  be  little  or  nothing  of  value  in 
the  unit  to  represent  the  capital  originally  invested  in  it. 
This  loss  of  capital  value  invested  in  plant  units  of  lim- 
ited life  is  similar  to  the  loss  of  capital  invested  in  an 
undertaking  with  a  limited  franchise.  Sound  financiering 
demands  that  the  loss  in  capital  value,  thus  brought  about 
by  years  of  service,  should  be  made  good  by  reserves  for 
depreciation  obtained  in  a  manner  already  fully  described 
in  the  preceding  chapters. 

131.  Physical  condition  not  a  direct  measure  of  loss 
of  value.  —  Depreciation  has  been  defined  as  the  loss  in 
value  of  an  investment  in  perishable  property  arising  from 
the  years  that  such  property  has  been  in  service. 

Objections  to  this  definition  have  been  raised  on  the 
ground  that  depreciation  is  made,  thereby,  to  depend 
entirely  upon  financial  considerations  and  that  such  a 
treatment  would  be  purely  theoretical  in  that  proper 
regard  was  not  given  to  the  physical  condition  of  the  plant 
at  the  precise  time  of  the  appraisal.  It  is  argued  that, 
if  this  definition  is  accepted,  it  would  make  the  loss  in 
value  dependent  upon  the  same  considerations  as  have 
been  shown  to  be  the  basis  upon  which  the  yearly  reserves 
for  depreciation  are  to  be  figured;  for,  if  the  case  of  a  single 
plant  unit  is  taken,  the  reserves  are  designed  simply  to 
have  in  hand  the  wearing  value  of  the  unit  at  the  end  of 
its  life.  It  is  argued  that  the  increment  to  the  reserves 
for  depreciation  which  is  set  aside  from  income  any  given 
year,  is  in  no  way  a  measure  of  any  loss  in  value  of  the 
physical  unit  during  that  year,  but  rather,  a  tax  upon  the 
income  of  the  undertaking  in  one  year  of  a  series  of  inter- 
mediate years,  designed  to  meet  a  future  condition 
which  will  demand  new  capital  to  replace  the  unit  when  it 


184  PUBLIC  UTILITIES 

becomes  unserviceable.  It  is  argued,  further,  that  the 
plant  unit  "  deteriorates "  year  by  year  and  that  this 
"deterioration"  is  the  true  measure  of  the  " depreciation" 
in  the  value  of  the  unit  during  the  intermediate  years  of 
its  life,  and,  being  a  physical  condition  of  the  plant,  can 
in  no  way  be  measured  by  the  purely  financial  considera- 
tions upon  which  the  reserves  for  depreciation  necessarily 
must  be  based. 

Such  a  line  of  reasoning  is  absolutely  faulty.  Any 
attempt  to  reconcile  "  deterioration "  with  "  deprecia- 
tion," at  any  intermediate  period  in  the  life  of  the  plant 
of  an  undertaking,  is  not  only  unnecessary  but  futile. 
The  error  in  any  such  attempt  arises  from  a  failure  on 
the  part  of  the  expert,  who  attempts  to  assign  a  definite 
loss  in  value  to  a  plant  unit  arising  from  its  partial  deterio- 
ration, to  recognize  the  fact  that,  if  it  can  be  proved  that 
a  plant  unit  can  and  should  be  retained  in  the  service  of 
the  public  for  a  definite  number  of  years,  in  other  words 
if  definite  agreement  has  been  reached  as  to  its  service- 
able life,  the  physical  " deterioration"  of  the  unit,  at  any 
time  during  its  life,  can  be  a  matter  affecting  its  intrinsic 
value  in  no  way  whatever.  Physical  deterioration  may 
enter  as  an  important  factor  in  affecting  the  serviceable 
life  of  the  unit  but  it  can  affect  its  value  in  that  way  only 
indirectly,  through  its  effect  in  a  lessened  number  of 
years  of  serviceability. 

When  it  has  been  recognized  that  physical  deteriora- 
tion affects  life  and,  as  a  consequence,  loss  in  value  in- 
directly, it  will  be  apparent  that,  if  the  years  that  a  unit 
can  and  will  be  retained  in  service  have  been  deter- 
mined, the  undertaking  has  an  investment  in  a  property 
of  a  definitely  limited  life.  The  value  of  the  investment 
diminishes  year  by  year,  during  each  year  of  the  term 
of  years  that  it  is  represented  by  perishable  physical 
property. 


DEPRECIATION  185 

132.  Determination  of  age.  —  In  the  last  chapter  the 
various  considerations  or  factors  necessary  for  an  esti- 
mate of  the  probable  life  of  a  plant  were  fully  discussed. 
But  a  valuation  is  made  always  at  a  date  intermediate 
within  the  life  of  the  units  of  which  the  plant  is  composed. 
At  this  time  the  several  units  have  the  probability  of 
various  years  of  remaining  serviceableness.  To  obtain 
the  loss  in  value  that  the  investment  in  perishable  prop- 
erty has  suffered,  it  is  necessary,  therefore,  to  determine 
the  age  of  the  perishable  property.  With  "age"  and 
"life"  known,  it  is  possible  to  calculate  the  loss  in  the 
value  of  the  investment,  in  other  words  to  ascertain  the 
"depreciation." 

It  is  unnecessary  in  the  present  discussion  of  this  sub- 
ject to  enter  into  any  detail  as  to  the  method  that  should 
be  employed  in  an  actual  appraisal  to  determine  the  age 
of  the  plant.  In  most  cases  it  may  be  best  to  have  an 
actual  inspection  made  of  some  or  all  of  the  plant  units 
by  a  specially  qualified  expert.  In  such  an  inspection  the 
expert  may  be  able  to  say  that  a  unit  can  be  retained  in 
service  for  a  number  of  years  in  the  future.  In  other 
cases  he  may  say  that  the  unit  is  in  a  certain  per  cent  con- 
dition. Whatever  method  he  may  employ,  the  age  is 
derived  by  expert  judgment,  having  in  mind  the  usual 
life  of  units  of  that  particular  kind.  For  some  classes  of 
property  detailed  inspection  may  not  be  required,  pro- 
vided the  records  are  such  that  from  them  the  age  can 
be  derived. 

The  bases  upon  which  losses  in  value  must  be  deter- 
mined are,  therefore,  figures  as  definite  as  it  may  be  pos- 
sible to  obtain,  showing  the  age  and  life  of  each  unit  of 
plant.  Such  figures  are  not  theoretical,  in  fact  they  can 
be  derived  only  by  men  most  expert  in  the  art  and  in  a 
practical  knowledge  of  the  effects  of  the  factors  which 
influence  the  life  of  such  elements  of  property. 


186  PUBLIC  UTILITIES 

133.  Mean  "  life"  and  mean  "  age."—  The  method  to 
be  employed  in  ascertaining  the  mean  life  of  plant  for 
the  purpose  of  figuring  the  annual  reserves  for  deprecia- 
tion was  described  in  section  104.  The  example  given 
in  that  section  was: 

$50,000  5  years' life  $10,000 

100,000  10  years'  life  10,000 

75,000  15  years'  life  5,000 

100,000  20  years'  life  5,000 

$325,000  $30,000 

It  was  there  shown  that  the  mean  life  of  such  a  plant 
would  be  found  by  dividing  $325,000  by  $30,000  and, 
consequently,  would  be  approximately  10.8  years. 

The  mean  age  must  be  determined  in  substantially  the 
same  manner.  To  illustrate  the  method  of  procedure 
it  will  be  assumed  that,  with  a  plant  such  as  is  described 
by  the  above  example,  the  appraisers,  having  in  mind 
all  factors  upon  which  the  existence  of  the  property 
depends,  have  agreed  upon  the  lives  attributed  to  the  dif- 
ferent elements.  If  the  appraisal  was  made  eleven  years 
after  the  above  plant  was  constructed,  the  experts  upon 
viewing  the  several  elements  of  which  the  plant  was 
composed  would  say  that  the  elements  of  the  class  having 
a  five-year  life  were  in  80  per  cent  condition  or  that  they 
had  four  years  of  remaining  life;  that,  with  the  second 
group,  they  were  in  90  per  cent  condition  or  had  nine 
years  of  remaining  life;  that  those  in  the  third  group 
were  in  approximately  27  per  cent  condition  or  had  four 
years  of  remaining  life;  and  the  fourth  was  in  45  per  cent 
condition  or  had  a  life  remaining  of  nine  years. 

This  could  be  represented  in  the  following  manner: 

$50,000  of  plant    1  year  old  out  of    5  years'  life      $10,000 

100,000  of  plant    1  year  old  out  of  10  years'  life         10,000 

75,000  of  plant  11  years  old  out  of  15  years'  life       55,000 

100,000  of  plant  11  years  old  out  of  20  years'  life       55,000 

$325,000  $130,000 


DEPRECIATION  187 

As  was  seen  in  section  105,  when  once  a  plant  has  been 
constructed,  there  will  have  to  be  paid  to  the  deprecia- 
tion reserves  a  sum  equal  to  the  cost  divided  by  the  life,~ 
and  this  sum  will  remain  the  same  no  matter  how  many 
times  the  component  portions  of  the  plant  have  to  be 
renewed.  Therefore  in  the  above  example,  $30,000  will 
have  to  be  set  aside  as  a  depreciation  reserve  every  year 
regardless  of  the  age  of  the  several  elements  of  which 
the  plant  is  constituted. 

As  $30,000  is  set  aside  each  year,  the  number  of  years 
required  to  aggregate  $130,000  would  be  approximately 
4.33.  In  other  words,  the  plant  has  passed  through  4.3 
years  of  a  10.8  life,  or  expressed  in  the  form  of  a  ratio  it 
has  existed  40  per  cent  of  its  life.  The  mean  age  is, 
therefore,  about  4.3  years. 

It  will  be  interesting  to  notice,  in  this  connection,  the 
variations  in  the  mean  age  of  the  hypothetical  plant  as 
shown  in  column  5  of  Table  III  given  in  section  109. 

134.  Determination  of  loss  of  value  a  problem  in 
accountancy.  —  The  figures  for  "mean  life"  and  "mean 
age"  developed  along  the  lines  above  indicated  supply  all 
the  information  required  for  a  determination  of  the  loss  in 
value  that  may  be  attributable  to  the  perishable  property 
of  a  public  utility.  These  two  figures  embody  the  expert 
knowledge  of  the  engineer  as  to  the  physical  condition  of 
the  plant  and  as  to  the  effect  of  all  other  conditions  which 
impose  a  limit  upon  its  usefulness.  These  figures  are  not 
theoretical  as  they  are  the  result  of  a  practical  knowledge 
of  the  particular  plant  under  appraisal  and  of  the  special 
conditions  under  which  it  may  be  operating.  They  tell 
the  whole  story  as  to  the  physical  condition  of  the  plant. 
The  plant  as  a  whole  has  been  in  service  a  certain  number 
of  years  and,  on  the  authority  of  the  best  expert  knowl- 
edge, can  be  expected  to  give  service  satisfactory  to  the 
public  for  a  certain  number  of  years  to  come. 


188  PUBLIC  UTILITIES 

When  these  two  figures  have  been  derived  by  the 
engineer  with  all  necessary  care  and  skill,  his  work  rela- 
tive to  depreciation,  or  loss  in  value  of  the  investment  in 
perishable  property,  is  completed.  In  a  valuation  of 
the  property  of  a  public  utility,  this  loss  in  value  becomes 
a  problem  for  the  accountant.  When  the  accountant 
has  been  provided  with  a  figure  showing  the  cost-new  of 
the  perishable  property  and  with  figures  showing  the  age 
and  probable  life  of  the  property,  he  has  all  the  data 
which  can  be  given  by  the  engineer  necessary  for  ascer- 
taining the  depreciation. 

The  problem  for  the  accountant  then  becomes  largely 
one  of  the  financial  operation  of  the  property.  The  prop- 
erty represents  an  investment  which  has  been  productive 
of  a  return  for  a  definite  number  of  years  in  the  past 
and  will  continue  to  be  productive  for  a  definite  number 
of  years  in  the  future.  When  the  return  upon  the  invest- 
ment, the  return  upon  readily  convertible  securities, 
the  demand  for  new  money  by  the  undertaking  and  the 
years  the  investment  may  continue  to  earn  are  consid- 
ered, the  accountant  must  ascertain  the  remaining  value 
in  the  investment  at  the  time  of  the  appraisal. 

135.  Shall  loss  in  value  due  to  age  be  figured  by 
straight  line  or  sinking  fund  method? — As  has  been  ex- 
plained in  Chapter  IX,  both  methods  of  making  depre- 
ciation reserves  are  equally  effective  in  producing  the 
wearing  value  of  a  unit  at  the  end  of  its  life.  But  an 
appraisal  is  made  at  an  intermediate  date,  within  the 
life  of  the  unit,  and,  at  that  time,  the  amount  in  reserve 
is  less  in  the  case  of  the  sinking  fund  method  than  if 
the  straight  line  method  had  been  employed.  It  was 
shown  that  the  choice  between  these  two  methods,  when 
reserves  for  depreciation  were  under  consideration,  de- 
pended largely  upon  the  demands  of  the  business  for 
new  capital  and  upon  the  financial  condition  of  the  enter- 


DEPRECIATION  189 

prise,  that  is  to  say  upon  the  cost  to  them  of  obtaining 
new  capital  for  needed  enlargements  of  the  plant. 

In  the  case  of  an  appraisal,  the  amount  that  the  under-" 
taking  has  charged  upon  its  books  as  reserves  for  depre- 
ciation cannot  be  accepted  as  a  criterion  for  the  loss  in 
value  which  should  be  assigned  by  the  appraiser.  The 
appraiser  must  employ  that  method  which  will  be  most 
equitable  to  all  interested.  In  an  appraisal  to  determine 
the  equity  of  rates,  the  method  should  be  that  which  is 
fairer  to  the  undertaking  and  to  the  public,  or,  in  the  case 
of  sale,  that  which  is  fairer  to  the  owner,  to  the  buyer 
and  to  the  public. 

136.  Return  to  undertaking  based  upon  fair  value  of 
property.  —  Before  entering  upon  a  detailed  discussion 
of  the  accountant's  problem  of  determining  the  loss  in 
value  arising  from  the  age  of  the  plant,  it  will  be  neces- 
sary to  reiterate  what  was  said  in  section  114.  This 
subject  is  introduced  again  as  it  is  felt  that  most,  if  not 
all,  of  the  controversy  which  has  existed  and  still  exists  as 
to  depreciation  would  be  removed  if  the  fact  was  defi- 
nitely understood  that  the  reserves  for  depreciation  do 
not  belong  to  the  undertaking  but  are  funds  held  in 
escrow  by  the  undertaking  for  the  benefit  of  the  public, 
arising  from  the  use  of  such  funds  in  making  good 
the  losses  in  the  wasting  assets  of  the  undertaking. 
These  funds,  in  a  sense,  belong  to  the  public  and  the 
undertaking  cannot  use  them  in  such  a  way  as  will  in- 
crease the  dividends  paid  to  the  stockholders.  If  the 
reserves  are  invested  in  outside  securities  the  returns 
upon  such  securities  are  added  to  the  reserves.  In  the 
same  way,  if  the  reserves  are  invested  in  needed  exten- 
sions of  plant,  the  earnings  derived  from  such  plant  exten- 
sions cannot  be  used  to  swell  the  returns  paid  by  the 
undertaking  to  its  stockholders.  Or,  speaking  somewhat 
loosely,  the  returns  paid  to  the  stockholders  cannot  be  a 


190  PUBLIC  UTILITIES 

fair  rate  of  return  based  upon  the  cost  of  plant  paid  for 
with  the  stockholders'  money  plus  the  cost  of  the  plant 
paid  for  with  the  depreciation  reserves.  On  the  con- 
trary, the  fair  return  to  the  stockholders  can  be  based 
only  on  the  legitimate  cost  of  the  plant  built  and  paid 
for  by  the  stockholders,  provided  the  present  depre- 
ciated value  of  such  property  equals  that  cost.  If  the 
enlarged  plant  obtained  with  the  depreciation  reserves 
is  capable  of  earning  more  than  a  fair  return  on  the 
stockholders'  investment  in  plant  after  all  proper  reserves 
for  depreciation  have  been  made,  then  the  benefit  thus 
obtained  should  accrue  to  the  public  in  the  form  of  lower 
rates,  as  it  is  their  money  which  has  contributed  to  this 
condition. 

If  the  above  proposition  is  accepted  and  kept  con- 
stantly in  mind,  it  is  felt  that  controversy  as  to  the 
proper  method  to  be  used  in  figuring  loss  in  value  arising 
from  age,  —  i.e.,  depreciation, —  will  be  entirely  removed. 

137.  Loss  in  value  of  plant  arising  from  age.  —  In 
attempting  to  find  the  value  of  the  plant  alone,  divested 
from  all  other  forms  of  property  of  an  undertaking,  it 
can  be  assumed  that  the  plant  may  have  been  enlarged 
by  the  use  of  some  or  all  of  the  depreciation  reserves  or 
that  no  additions  from  such  reserves  have  been  made 
at  all.  It  makes  no  difference  whatever. 

A  plant  of  a  mean  life  of  n  years  must  be  increased  £ 
in  cost  each  year  in  order  that  its  present  value  may 
equal  at  all  times  its  original  cost;  that  is  to  say,  depre- 
ciation reserves  equal  to  £  the  total  cost  of  the  plant 
must  be  invested  in  plant  each  year  in  order  that  the 
stockholders'  investment  in  plant  may  be  maintained 
unimpaired. 

The  above  statement  will  appear  to  the  advocates  of 
the  sinking  fund  method  of  making  reserves  as  an  arbi- 
trary assumption  of  the  straight  line  method.  It  is  not 


DEPRECIATION  191 

so.  It  must  be  remembered  that  the  present  case  has 
reference  to  plant  cost  and  value  alone.  Reserves,  if 
invested  in  outside  securities,  do  not  form  any  portion 
of  the  plant,  and,  consequently,  are*not  concerned  in  the 
present  discussion.  As  was  shown  in  section  107,  if 
reserves  invested  in  plant  have  been  set  aside  for  each 
unit  on  the  sinking  fund  method  the  public  through  the 
undertaking  must  pay  both  the  annuity  and  interest 
and,  consequently,  the  mean  or  average  reserves  for  the 
entire  plant  is  virtually  an  even  increment  each  year  of  ~ 
of  the  cost. 

There  is  a  second  point  that  must  be  appreciated  and 
that  is  that  the  age  of  the  plant  as  given  by  the  engineer 
has  no  bearing  whatever  upon  how  long  the  plant  has 
been  in  existence.  Cases  are  frequently  cited,  in  discus- 
sions of  this  question,  of  the  value  of  plants  which  have 
been  in  existence  four,  five  or  x  years  out  of  a  life  of  10, 
12  or  y  years.  Such  cases  always  lead  to  confusion.  A 
plant  that  had  been  in  existence  5  years  out  of  a  ten-year 
life  might  have  a  mean  life  of  less  than  four  years  if  proper 
reserves  had  been  made  and  invested  in  plant  extensions. 
An  undertaking  that  had  been  in  existence  16  or  17  years 
and  another  similar  in  all  respects  that  had  been  in  exist- 
ence 25  or  26  years  might  have  plants  of  the  same  age 
if  renewals  had  been  properly  made  in  both  cases.  In 
practice  the  years  of  age  and  life  alone  are  known,  and 
these  two  figures  with  the  cost-new  at  the  present  time 
are  sufficient. 

But  even  accepting  the  uniformity  of  yearly  payments 
to  the  reserves  on  the  principle  of  £  the  cost  and  the  in- 
vestment of  such  reserves  in  needed  plant  extensions,  it 
is  difficult  for  many  to  see  why,  when  the  loss  in  value  at 
the  time  of  an  appraisal  is  determined,  the  straight  line 
rather  than  the  sinking  fund  method  should  be  used. 
This  difficulty  arises  principally  from  a  lack  of  apprecia- 


192  PUBLIC  UTILITIES 

tion  that  the  compounding  of  the  sinking  fund  is  really 
cared  for  by  the  figure  assigned  as  the  mean  age. 

This  may  be  made  clearer  by  a  consideration  of  a  practi- 
cal case.  Let  the  case  be  that  illustrated  in  Table  III, 
page  153,  of  a  plant,  the  original  cost  of  which  was  $100, 000. 
The  mean  life  of  this  plant  was  ten  years  and  all  of  the 
reserves  required  to  make  good  the  original  investment 
of  the  stockholders  had  been  invested  in  plant  needed  to 
supply  the  public  with  service.  Then  the  cost-new  of  the 
plant  any  number  of  years  m  from  the  date  of  the  con- 
struction of  the  original  plant  will  be  $100,000  (1  +  A)™. 
It  is  really  $100,000  compounding  at  ten  per  cent  annually. 
The  plant  purchased  with  the  stockholders'  money  is 
shown  in  column  3.  It  shows  that  the  original  invest- 
ment, made  by  the  stockholders,  is  not  increased  for  the 
first  ten  years  but,  thereafter,  the  undertaking  must  sup- 
ply new  money  to  pay  for  needed  renewals. 

It  must  be  remembered  that  the  above  example  and 
the  figures,  representing  the  financial  conditions  relative 
to  plant  cost,  have  been  calculated  on  arbitrary  and 
theoretically  correct  lines  in  order  that  a  test  may  be 
made  of  the  accuracy  of  the  straight  line  method  for  use 
in  a  determination  of  what  portion  of  the  plant-cost-new 
had  been  built  with  stockholders'  money  and  what  portion 
with  the  money  contributed  by  the  public  to  hold  good 
the  stockholders'  investment.  When  the  necessity  of  an 
appraisal  arises,  the  number  of  years  from  the  date  of  the 
construction  of  the  original  plant  is  not  known  and  is  not 
useful  in  any  way.  The  figures  represented  by  m  were 
useful  only  in  the  calculations  involved  under  column 
2  of  Table  III,  and,  for  the  practical  purposes  of  an  ap- 
praisal, must  be  neglected. 

Attention  must  be  directed  to  "mean  age"  of  the  plant 
as  shown  in  column  5  of  Table  III.  Each  annual  incre- 
ment to  the  plant  tends  to  alter  the  mean  age  of  the 


DEPRECIATION  193 

plant.  The  mean  age  is  one  of  the  three  figures  deter- 
mined by  the  engineer  for  the  use  of  the  accountant,  the 
other  two  being  cost-new  and  the  mean  life. 

If  now  the  engineer,  in  his  study  of  the  plant  described 
in  the  present  example,  reported  a  mean  age  of  the  plant 
as  it  exists  to-day  of  3.79  years,  a  cost-new  of  $161,051, 
and  a  mean  life  of  ten  years,  then  the  accountant  can  say 
that  A/OIF  of  the  cost-new  represents  the  amount  that 
has  been  contributed  by  the  public  as  depreciation 
reserves,  and  the  remainder  represents  the  investment 
of  the  undertaking.  TVA  of  $161,051  is  $61,051.  The 
difference  between  $161,051  and  $61,051  is  $100,000, 
which  is  the  amount  of  the  stockholders'  money  which 
has  been  invested  in  the  property. 

One  more  example  only  need  be  given  to  test  the 
accuracy  of  the  straight  line  method  in  separating  the 
stockholders'  investment  from  the  investment  made  with 
the  reserves.  The  mean  age  may  be  given  as  3.75,  the 
cost-new  as  $417,725,  and  the  mean  life  as  10  years. 
Then  by  the  straight  line  method  the  public's  contribution 
to  the  enterprise  would  be  TVoir  of  $417,725,  or  $156,674, 
and  the  stockholders'  contribution  $261,051,  which  is  the 
precise  amount,  as  shown  in  Table  III,  that  should  have 
been  contributed  by  the  undertaking. 

There  can  be  no  question  whatever  of  the  accuracy  of 
the  statement  made  in  the  first  portion  of  the  present 
section,  that,  in  order  to  conserve  the  full  value  of  an 
investment  in  a  wasting  asset  such  as  a  utility  plant, 
reserves  equal  to  the  total  cost  divided  by  the  mean  life 
of  the  plant  must  be  made  each  year;  there  can  be  no 
question  that,  if  these  reserves  have  been  invested  in  plant, 
the  difference  between  the  cost-new  and  the  amount  that 
should  have  been  set  aside  as  reserves  should  be  the  stock- 
holders' investment.  When  reserves  have  been  made 
properly  and  the  undertaking  has  been  financed  properly, 


194  PUBLIC  UTILITIES 

the  straight  line  method  accurately  separates  these  two 
classes  of  investment,  as  has  been  illustrated  in  the  fore- 
going examples. 

The  conditions  shown  in  Table  III  and  illustrated  by 
the  two  above  examples  are  based  upon  ideal  conditions. 
There  are  two  classes  of  abnormal  conditions  which  will 
be  met  in  practice,  —  one  when  inadequate  reserves  for 
depreciation  had  been  made  and  the  other  when  the  under- 
taking had  taken  more  from  the  public  than  was  required 
for  the  plant  increments  necessary  to  make  good  their 
original  investment. 

If  the  reserves  had  been  inadequate,  then  by  the 
straight  line  method  there  will  be  shown  that  portion  of 
the  cost-new  which  should  have  been  represented  by  re- 
serves. When  this  figure  is  subtracted  from  the  cost- 
new  the  difference  will  represent  a  sum  less  than  that 
which  had  been  contributed  by  the  stockholders.  In  other 
words,  the  amount  representative  of  the  stockholders' 
share  in  the  enterprise  is  less  than  it  would  have  been  if 
the  reserves  for  depreciation  had  been  properly  made. 
Such  a  conclusion  is  absolutely  right,  as  the  undertaking 
must  guarantee  the  public  at  all  times  a  continuation  of 
the  enterprise  by  adequate  reserves. 

If  the  reserves  had  been  too  large  the  difference  between 
cost-new  and  reserves  for  depreciation  would  be  greater 
than  the  stockholders'  investment  and  should  be  treated 
as  a  surplus. 

138.  Loss  in  value  of  property  consisting  of  plant  and 
reserves. — If  an  undertaking  has  reserves  in  outside  secu- 
rities in  addition  to  the  plant  used  for  giving  service  to 
the  public,  the  first  impression  might  be  that  the  value  of 
the  property  would  be  the  sum  of  the  present  value  of  the 
plant, — as  ascertained  by  the  method  above  described,  — 
and  the  reserve  fund  represented  by  the  outside  securities. 
Closer  examination  will  show  that  this  cannot  be  the  case. 


DEPRECIATION  195 

At  the  time  of  an  appraisal  the  amount  of  money  repre- 
sented by  the  securities  purchased  with  the  reserves  is  the 
accumulations  of  an  annuity  which  the  public  pays  to  the 
undertaking.  The  annuity  is  assured  to  the  undertaking 
by  the  public  so  long  as  a  high  grade  of  service  is  provided, 
and  must  be  reserved  by  the  undertaking  even  before  any 
return  is  paid  to  stockholders.  This  annuity  with  its 
interest  accretions  should  equal  the  cost-new  of  the 
perishable  property  at  the  end  of  its  life.  This  must  be 
the  case  in  order  that  the  public  may  be  guaranteed  a 
continuation  of  the  service  after  the  perishable  property 
has  passed  away. 

In  a  valuation  the  reserve  funds  and  plant  are  the 
property  of  the  undertaking;  they  cannot  be  divorced 
from  each  other.  It  cannot  be  said  that  the  plant  is 
worth  a  certain  amount  and  the  depreciation  reserve  is  a 
certain  amount  and  the  sum  of  the  two  is  the  value  of  the 
property.  It  is  not  right  even  to  say,  in  a  case  where 
ample  depreciation  reserves  have  been  made  and  are 
sufficient  at  the  date  of  appraisal  to  insure  the  full  cost 
of  the  property  at  the  end  of  its  life,  that  the  present 
value  of  the  physical  property  is  the  cost-new  less  the 
reserves  for  depreciation.  If  the  undertaking  has  such 
an  amount  in  reserve  that,  with  it  and  the  accumulations 
derived  from  the  annuity  and  interest  that  will  be  received 
during  the  remaining  years  of  the  plant  life,  the  cost  of 
the  property  will  be  recovered,  then  the  cost  of  the  prop- 
erty is  its  fair  present  value.  Or,  speaking  more  generally, 
the  present  value  of  the  property  is  the  amount  that  will 
be  in  the  reserves  for  depreciation  at  the  end  of  the  life 
of  the  property,  based  upon  the  present  reserves,  the  pres- 
ent current  rate  of  interest  and  a  proper  and  reasonable 
annuity  each  year  of  the  remaining  years  of  life. 

When,  therefore,  at  the  time  of  an  appraisal  reserves 
are  found  as  a  portion  of  the  property  of  the  company, 


196  PUBLIC  UTILITIES 

the  method  of  ascertaining  the  loss  of  value  in  the  property 
as  a  whole  must  be  determined  by  the  use  of  calculations 
based  on  the  sinking  fund  method. 

Justice  to  the  undertaking  requires  that  this  method 
be  employed  for  the  reason  that  it  may  be  claimed  that 
this  was  the  method  which  had  been  employed  in  the 
accumulations  of  the  reserves,  and  that  it  was  in  conse- 
quence of  the  use  of  this  method  that  the  reserves  were 
less  at  the  time  of  an  appraisal  than  would  appear  to  be 
necessary  for  maintaining  the  value  of  the  investment 
in  perishable  property. 

139.  Justice  of  the  rule  as  to  use  of  straight  line  or 
sinking  fund  method.  —  It  will  be  seen  that  a  rule  has 
been  laid  down  in  the  last  two  sections  that,  when  the 
property  of  a  public  utility  consists  of  plant  alone,  the  loss 
in  value  must  be  determined  by  the  straight  line  method 
and,  when  the  property  consists  of  plant  and  depreciation 
reserves,  the  loss  in  value  must  be  ascertained  by  means  of 
what  has  been  called  the  sinking  fund  method. 

There  can  be  no  question  whatever  as  to  the  full  justice 
of  the  straight  line  method  when  the  property  consists  of 
plant  alone.  On  the  other  hand,  a  contention  might  be 
made  that  the  argument,  which  has  been  made  so  often 
in  the  presentation  of  this  subject,  as  to  the  necessity  of 
the  public  being  guaranteed  the  continuation  of  the 
service  by  ample  reserves,  was  not  given  its  due  weight 
in  such  cases  as  all  reserves  had  been  invested  in  plant, 
whereas  it  was  made  the  controlling  consideration  when 
the  sinking  fund  method  was  discussed.  Such  a  con- 
tention would  have  little  weight  if  viewed  from  a  practical 
standpoint.  An  undertaking  which  has  a  plant,  which 
at  its  depreciated  value  is  equal  to  its  investment  cost  and 
is  earning  a  full  return,  would  have  no  difficulty  whatever 
in  raising  money  to  pay  for  extensions,  in  other  words, 
to  pay  back  to  the  reserves  the  money  of  the  public  which 


DEPRECIATION  197 

had  been  invested  in  the  extensions.  As  a  matter  of  fact, 
the  public  is  guaranteed  a  service,  in  cases  of  this  kind, 
not  to  be  sure  of  as  great  a  magnitude  as  is  represented 
by  the  enlarged  plant,  in  which  they  have  an  interest,  but 
of  the  same  size  as  the  undertaking  itself  had  bought  with 
its  own  money  and  upon  which  alone  it  is  receiving  a 
return. 

It  is  with  the  justice  of  the  sinking  fund  method  as 
above  outlined  that  a  serious  doubt  can  be  raised  in  such 
cases  as  the  undertaking  has  not  required  all  of  the 
reserves  for  extension  but  has  invested  a  portion  only  of 
the  reserves  in  plant,  and  in  such  other  cases  as  the 
undertaking  has  not  been  able  to  make  needed  reserves 
for  depreciation.  The  above  rule  seems  to  be  perfectly 
equitable  for  cases  where  all  reserves  have  been  made 
and  used  in  a  theoretically  ideal  manner,  but  such  cases 
rarely  occur  in  practice. 

It  will  be  necessary  to  consider,  first,  normal  cases 
where  the  property  consists  of  plant  and  reserves,  and  later 
to  prove  that  such  cases  as  have  just  been  referred  to  can 
be  treated  perfectly  equitably  by  the  sinking  fund  method. 

140.  "Pseudo"  mean  age.  —  Before  entering  upon  a 
discussion  of  the  calculations  of  the  loss  of  value  of  a 
property  consisting  of  plant  and  reserves,  it  is  necessary  to 
call  attention  to  a  correction  that  must  be  made  in  the 
ages  of  plant  when  a  sinking  fund  and  its  interest  accre- 
tions are  involved.  As  has  been  shown,  the  accumula- 
tions of  annuity  and  interest  amount  to  the  total  cost-new 
of  the  plant  at  the  end  of  a  life  of  n  years.  The  mean  of 
such  accretions  to  the  reserves  must  be,  therefore,  the 
cost-new  divided  by  n  and,  in  the  straight  line  method, 
the  annual  increments  are  uniformly  this  figure,  —  cost- 
new  divided  by  n.  In  the  sinking  fund  method,  however, 
the  yearly  increment  is  affected  by  the  compound  interest 
upon  the  sums  already  in  hand;  the  consequence  is  that 


198 


PUBLIC  UTILITIES 


the  mean  age  as  derived  in  the  manner  described  in  section 
133  must  be  modified  somewhat  to  care  for  the  variation 
in  yearly  increments.  Clearly  the  correction  will  be 
dependent  upon  the  rate  of  interest  and  the  length  of  life. 
With  plant  of  the  same  life  and  with  the  usual  possible 
rates  of  interest,  the  correction  will  not  be  large,  but  for 
an  accurate  determination  of  losses  in  value  this  correction 
in  age  should  be  taken  into  account. 

It  is  not  necessary  to  describe  in  detail  the  method  of 
deriving  this  corrected  age  or,  as  it  will  be  called,  the 
"pseudo"  mean  age  of  the  property.  An  idea  of  its 
magnitude  may  be  derived  from  the  mean  age  of  a  plant 
growing  as  described  in  section  137,  with  a  life  of  ten 
years,  and  interest  at  the  rate  of  three  per  cent. 

TABLE  V 

EXAMPLE  OF  RELATION  BETWEEN  MEAN  AGE  AND  PSEUDO  MEAN  AGE 

10-Year  Life 


End  of  Year 

Mean  Age 

Pseudo  Mean  Age 
3%  Compound  Interest 

1 

.909 

.910 

2 

1.735 

1.741 

3 

2.486 

2.500 

4 

3.169 

3.199 

5 

3.790 

3.836  . 

6 

4.355 

4.422 

7 

4.868 

4.960 

8 

5.335 

5.460 

141.  Loss  in  value  of  property  when  all  reserves  have 
been  held  invested  in  outside  securities.  —  The  condition 
considered  in  this  section  is  more  theoretical  than  usual 
as  it  is  assumed  that  reserves  have  been  made  properly, 
invested  in  outside  securities  and  that  the  plant  has  been 
built  entirely  with  money  contributed  by  the  stockholders 
of  the  undertaking.  There  are  two  classes  of  cases  that 


DEPRECIATION 


199 


may  be  considered.  The  first  typical  case  is  that  where  a 
plant  had  been  built  originally  of  ample  size  and  had  not 
been  increased  by  the  use  of  money  taken  from  the  reserves 
for  depreciation;  the  second  is  that  where  the  plant  had 
increased  in  size  but  the  money  required  for  extensions 
had  been  obtained  from  the  stockholders.  In  both  cases 
it  is  assumed  that  reserves  of  proper  and  adequate  amounts 
have  been  made  on  a  sinking  fund  basis. 

As  an  illustration  of  the  first  case,  let  a  plant  be  assumed 
which  cost  originally  $100,000,  and  has  a  mean  life  of  ten 
years.  Let  it  be  assumed  further  that  reserves  have  been 
made  regularly  on  a  three  per  cent  yearly  basis.  Then 
the  value  of  the  property  at  different  periods  will  be  as 
shown  in  the  following  table. 


TABLE  VI 

EXAMPLE  OF  CALCULATION  OF  VALUE  OF  PROPERTY  CONSISTING  OF  PLANT 

AND  RESERVES 

All  Reserves  Made  on  Sinking  Fund  Basis  and  Invested  in  Outside  Securities 
Drawing  3%  Interest 


End 
of 
Year 

Cost-New 

Mean 
Age 

Reserve 
Fund 

Years 
Remain- 

,   life 

Compound 
Interest 

Annuity 

Total 

(1) 

(2) 

(3) 

(4) 

(5) 

(6) 

(7) 

(8) 

0 

$100,000 

0 

0 

10 

0 

0 

$100,000 

1 

100,000 

1 

$8,723.06 

9 

$11,382 

$88,618 

100,000 

2 

100,000 

2 

17,707.81 

8 

22,432 

77,568 

100,000 

3 

100,000 

3 

26,962.10 

7 

33,160 

66,840 

100,000 

4 

100,000 

4 

36,494.02 

6 

43,576 

56,424 

100,000 

5 

100,000 

5 

46,311.90 

5 

53,688 

46,312 

100,000 

6 

100,000 

6 

56,424.32 

4 

63,506 

36,494 

100,000 

7 

100,000 

7 

66,840.11 

3 

73,038 

26^962 

100,000 

8 

100,000 

8 

77,568.37 

2 

82,292 

17,708 

100,000 

9 

100,000 

9 

88,618.48 

1 

91,277 

8,723 

100,000 

10 

100,000 

10 

100,000.00 

0 

0 

0 

0 

11 

100,000 

1 

8,723.06 

9 

11,382 

88,618 

100,000 

12 

100,000 

2 

17,707.81 

8 

22,432 

77,568 

100,0(50 

200  PUBLIC  UTILITIES 

Table  VI  on  page  199  shows  the  financial  condition  of 
the  property  for  each  year  of  its  life.  Column  1  shows 
the  years  from  the  original  construction  of  the  plant,  —  a 
figure  unknown  at  the  time  of  an  appraisal  and  introduced 
here  simply  to  show  the  amount  that  should  actually  be 
in  the  reserve  fund  to  preserve  the  value  of  the  investment 
intact.  The  reserve  funds,  which  should  be  in  hand  at  the 
end  of  each  year,  are  shown  in  column  4.  At  the  time  of  an 
appraisal  the  cost-new,  the  mean  age  and  the  amount  in 
reserve  would  be  known.  From  the  mean  age  the  years 
of  remaining  life,  column  5,  are  known.  The  undertaking 
will  obtain  the  interest  compounding  at  3  per  cent  on 
the  reserves  during  each  of  the  remaining  years  of  life, 
column  6,  and  an  annuity  of  $8,723.06  and  interest  accu- 
mulations during  the  same  period,  column  7.  At  the  end 
of  the  life  of  the  property,  the  amount  in  hand  will  be  the 
sum  of  these  two  figures,  —  column  6  plus  column  7,  - 
shown  in  column  8. 

To  take  an  example:  cost-new,  $100,000,  mean  age  6 
years,  and  depreciation  reserves  $56,424.32.  There  are 
therefore  4  years  of  remaining  life.  $56,424  at  compound 
interest  at  3  per  cent  for  4  years  will  amount  to  $63,506. 
There  will  be  an  annuity  $8,723  for  4  years  and  with  its 
interest  accretions  it  will  amount  to  $36,494.  The  sum 
of  these  two  figures,  —  $63,506  and  $36,494,  —  will  be 
the  present  value  of  the  property,  in  this  case  equal  to  the 
cost-new. 

The  second  typical  normal  case  which  will  be  considered 
will  be  that  of  a  plant  which  has  been  growing  and  the 
additions  have  been  paid  for  by  the  stockholders.  As  an 
example  of  this  case,  the  conditions  considered  in  section 
137  will  be  taken.  It  will  be  assumed,  therefore,  that  a 
plant  originally  costing  $100,000  had  been  increased  by 
ten  per  cent  of  the  cost-new  at  the  end  of  each  year. 
Ample  reserves  had  been  made  each  year  and  held  in  a 


DEPRECIATION 


201 


sinking  fund  upon  which  interest  at  three  per  cent  was 
obtained. 

TABLE  VII 

EXAMPLE  OP  CALCULATION  OF  VALUE  OP  PROPERTY  CONSISTING  OP  PLANT 

AND  RESERVES 

All  Reserves  Properly  Made  and  Held  in  3%  Sinking  Fund 


End 
of 
Year 

Cost-New 

Pseudo 
Mean 
Age 

Reserve 
Fund 

Re- 
maining 
Life 

Compound 
Interest 

Annuity 

Total 

(1) 

(2) 

(3) 

(4) 

(5) 

(6) 

(7) 

(8) 

0 

$100,000 

0 

0 

10 

0 

0 

$100,000 

1 

110,000 

.91 

$8,723 

9.08 

$11,412 

$98,588 

110,000 

2 

121,000 

1.74 

18,580 

8.25 

23,718 

97,282 

121,000 

3 

133,100 

2.50 

29,692 

7.49 

37,060 

96,040 

133,100 

4 

146,410 

3.19 

42,194 

6.80 

51,591 

94,819 

146,410 

5 

161,051 

3.83 

56,231 

6.16 

67,467 

93,584 

161,051 

6 

177,156 

4.42 

71,966 

5.57 

84,860 

92,296 

177,156 

7 

194,872 

4.96 

89,579 

5.03 

103,952 

90,920 

194,872 

8 

214,359 

5.46 

109,265 

4.53 

124,940 

89,419 

214,359 

9 

235,795 

5.92 

131,241 

4.07 

148,039 

87,756 

235,795 

10 

259,374 

2.41 

55,747 

7.58 

69,764 

189,610 

259,374 

As  will  be  seen  froin  the  above  table,  the  undertaking 
having  made  proper  reserves  for  depreciation  will  have  in 
hand,  at  the  periods  noted,  the  funds  shown  in  column  4 
as  well  as  perishable  property  of  costs-new,  at  the  same 
times,  of  the  values  given  in  column  2.  The  undertaking 
will  obtain  compound  interest  on  the  reserves  during  the 
remaining  years  of  life.  The  amount  of  the  reserves, 
shown  in  column  4,  when  placed  at  compound  interest  for 
the  remaining  life  of  the  plant  in  each  case  is  given  in 
column  6.  Moreover,  the  undertaking  can  obtain  an 
annuity,  figured  at  current  rates  of  interest,  upon  the 
cost-new  of  the  perishable  property.  The  aggregates  of 
these  annuities  and  interest  for  each  value  of  the  plant- 
new  at  the  end  of  the  life  of  the  property  are  shown  in 
column  7.  The  sum  of  the  reserve  fund  in  hand  at  the 
time  of  valuation  plus  interest  accretions  (column  6)  and 


202  PUBLIC  UTILITIES 

the  annuity  plus  interest  (column  7)  gives  column  8,  and 
shows  that  at  the  end  of  the  life  of  the  plant  there  will  be  a 
sufficient  reserve  in  hand  to  replace  the  property  which 
has  become  unserviceable.  It  follows  from  this  that  the 
full  value  of  the  investment  in  perishable  property  has 
been  maintained  throughout  the  life  of  the  plant  and, 
consequently,  that  its  present  value  is,  at  all  times  within 
that  period,  equal  to  the  cost-new.  In  other  words,  the 
investment  has  suffered  no  loss  in  value  and,  consequently, 
has  suffered  no  depreciation. 

As  an  illustration  the  case  can  be  taken  of  a  property 
having  a  pseudo  mean  age  of  4.96  years  and  consisting  of 
a  plant  of  which  the  cost-new  is  $194,872,  and  of  deprecia- 
tion reserves  amounting  to  $89,579.  The  remaining  life  of 
the  plant  is  approximately  5.03  years  and,  in  consequence, 
the  $89, 579  will  obtain  compound  interest  during  that  time. 
$89,579  plus  the  compound  interest  will  amount  to  $103,952. 
The  cost-new  of  the  plant  is  $194,872  and  necessarily  is 
independent  of  the  cost  of  any  additions  or  extensions  that 
may  be  made  at  a  later  date.  The  annuity  which  the  un- 
dertaking will  receive  during  the  remaining  5.03  years  of 
life  is  approximately  $17,000.  These  annuities  plus  the 
interest  upon  them  will  aggregate  $90,920.  $103,952  plus 
$90,920  equals  $194,872,  —  the  cost-new  of  the  perishable 
property  at  the  time  of  the  appraisal. 

142.  Loss  in  value  of  property  consisting  of  plant, 
built  partly  with  reserves,  and  of  reserves.  —  The  case  of 
a  property  consisting  of  plant  and  reserves  but  wherein 
a  portion  of  the  plant  has  been  built  with  some  of  the 
reserves  is  more  usual  than  the  cases  described  in  the  pre- 
vious section.  The  method  of  calculating  the  present 
value  of  the  property  as  a  whole  will  be  the  same,  for  the 
reason  that  injustice  in  some  cases  might  be  done  to 
the  undertaking  if  this  method  were  not  employed.  As 
the  illustration  given  below  will  show,  reserves  which  are 


DEPRECIATION 


203 


made  on  the  sinking  fund  method  presuppose  that  the 
amounts  set  aside  are  to  obtain  the  benefit  of  interest  accu- 
mulations. If  sums  are  taken  from  the  reserves,  —  which 
have  been  obtained  on  the  sinking  fund  basis  and,  conse- 
quently, are  less  than  the  cost-new  divided  by  the  life, — for 
the  purpose  of  paying  for  plant  extensions,  the  undertaking 
suffers  a  loss.  If  reserves  are  to  be  used  for  enlargements 
of  plant,  as  in  many  cases  it  is  wise  to  do,  then  the  reserves 
should  be  made  on  a  straight  line  basis  even  though  at  the 
time  of  an  appraisal  it  may  be  shown  that  there  is  a  greater 
value  in  the  property  than  its  actual  cost-new. 

This  is  well  illustrated  by  the  following  example.  For 
this  case  let  it  be  assumed  that  original  cost  of  the  plant 
was  $100,000;  that  it  had  a  ten-year  life;  that  reserves 
had  been  made  on  a  sinking  fund  basis;  but  that  at  the 
end  of  two  years  $15,000  was  taken  from  the  reserve 
funds  to  pay  for  needed  extensions  of  the. plant. 

The  following  table  illustrates  the  changes  in  the  value 
of  the  property  under  the  assumed  conditions : 


TABLE  VIII 

EXAMPLE  OP  CALCULATION  OF  VALUE  OF  PROPERTY  CONSISTING  OF  PLANT 

AND  RESERVES 

Portion  of  Reserves,  Made  on  Sinking  Fund  Basis,  Invested  in  Plant 


End 
of 
Year 

Cost-New 

Mean 

Age 

Reserve 
Fund 

Remain- 
ing 
Life 

Compound 
Interest 

Annuity 

Total 

(1) 

(2) 

(3) 

(4) 

(5) 

(6) 

(7) 

(8) 

0 

$100,000 

0 

0 

10 

0 

0 

$100,000 

1 

100,000 

1 

$8,723 

9 

$11,382 

$88,618 

100,000 

2 

115,000 

1.74 

2,708 

8.25 

3,456 

92,400 

95,856 

3 

115,000 

2.74 

12,821 

7.25 

15,886 

79,970 

95,856 

4 

115,000 

3.74 

23,237 

6.25 

27,955 

67,901 

95,856 

This  example  need  not  be  carried  farther.     It  shows 
that,  although  reserves  had  been  made  in  amounts  suffi- 


204  PUBLIC  UTILITIES 

ciently  large  to  recover  the  cost-new  of  the  property  by 
the  end  of  its  life  on  a  sinking  fund  basis,  the  removal  of 
$15,000  from  the  reserves  for  depreciation  had  reduced  the 
value  of  the  property.  The  present  value  of  the  prop- 
erty, as  shown  by  column  8,  is  $95,856,  which  shows  that 
the  undertaking's  investment  of  $100,000  has  diminished 
in  value  by  $4,144,  which  means  that  the  undertaking 
by  investing  this  sum  in  plant  rather  than  by  holding 
it  in  reserves  has  lost  the  compound  interest  on  $15,000 
for  more  than  eight  years. 

143.  General  consideration  of  loss  in  value  due  to  age. 
-The  above  cases  sufficiently  illustrate  the  methods  to  be 
used  in  calculations  of  the  loss  in  value  of  investments  in 
perishable  property  or,  as  it  is  more  frequently  called, 
of  the  depreciation  in  the  value  of  property.  In  the  last 
case  it  was  assumed  that  a  portion  of  the  reserve  funds 
had  been  used  for  the  purchase  of  new  plant.  The  method 
of  treatment  would  have  been  the  same  if  the  reserves  in 
the  earlier  years  had  been  inadequate  or  if  the  $15,000 
had  been  paid  outright  to  the  stockholders.  The  loss  in 
the  value  of  the  property  would  have  been,  however, 
much  greater.  In  such  a  case  the  cost-new  would  have 
been  found  to  be  only  $100,000  and,  in  consequence,  the 
annuity  on  a  sinking  fund  basis  could  have  been  only 
$8,723.  The  mean  life  at  the  period  chosen  would  have 
been  two  years.  The  $2,708  at  compound  interest  for 
eight  years  would  have  been  $3,430,  and  the  amount  of 
the  annuity  and  interest  at  the  end  of  eight  years  would 
have  been  $77,568.  The  sum  of  these  two  figures  is 
$80,998,  which  shows  a  depreciation  of  $19,002. 

The  above  consideration  of  depreciation  presents 
methods  which,  as  far  as  general  rules  are  concerned,  are 
fair  and  equitable  to  both  the  undertaking  and  the  public 
in  questions  concerning  rates  and  to  both  buyer  and  seller 
as  well  as  to  the  public  in  cases  of  condemnation  or  sale. 


DEPRECIATION  205 

General  rules  of  this  kind  cannot  be  followed  rigidly  in 
all  cases.  Special  conditions  require  special  treatment. 

144.  Question  as  to  necessity  of  reserves  sufficient  to 
maintain  value  of  original  investment.  —  Attention  has 
been  called  to  the  fact  that  the  mean  age  of  most  large 
properties,  especially  those  which  have  been  for  some  time 
in  service  and  are  composed  of  many  different  classes  of 
elements  of  varying  lives,  approaches  a  figure  approxi- 
mately one-half  of  the  mean  life  of  the  entire  perishable 
property.  It  is  argued  that  this  mean  age  will  rarely, 
if  ever,  be  less  than  twenty  per  cent  of  the  total  mean  life 
and,  consequently,  that  in  all  such  large  older  properties 
there  is  always  at  least  a  25  per  cent  loss  in  value.  This 
item  has  been  called  the  normal  wear.  It  is  argued 
further  that  this  loss  in  value  "  represents  the  necessary 
shrinkage  of  the  property  at  the  start  from  the  original 
investment.  This  shrinkage  is  something  that  cannot 
and  need  not  ever  be  restored.  It  should  be  taken  care 
of  not  by  a  depreciation  fund  but  by  an  amortization  of  a 
portion  of  the  capital." 

It  is  apparent  that  the  idea  presented  by  the  above  argu- 
ment is  that  a  part  of  the  depreciation  reserve  funds,  if  they 
have  been  accumulated  in  the  manner  above  described, 
will  never  be  required  for  renewals  particularly  in  large, 
old  and  growing  undertakings.  In  consequence  of  this  a 
portion  of  the  depreciation  reserve  fund  serves  no  useful 
purpose  other  than  that  of  maintaining  the  value  of  the 
original  investment  of  the  stockholders  in  the  enterprise, 
and,  as  a  consequence,  it  maintains  an  unnecessarily  high 
value  upon  which  the  public  must  pay  a  return  in  the 
form  of  rates  higher  than  would  be  required  if  this  value 
were  reduced  by  an  amortization  of  a  portion  of  the 
original  cost  to  the  undertaking. 

This  idea  is  interesting  theoretically  but  is  probably 
of  little  practical  value  owing  to  the  nature  of  most  large 


206  PUBLIC  UTILITIES 

public  utilities  in  this  country.  Most  public  utilities  in 
this  country  are  growing  and  there  is  a  constant  demand 
for  new  money  to  pay  for  the  required  extensions  of  plant 
to  meet  the  needs  of  growing  communities  or  of  larger  uses 
of  the  utility.  This  new  plant,  if  purchased  with  money 
taken  from  the  depreciation  reserves  acquired  on  a  straight 
line  basis,  will  reduce  by  that  amount  the  money  which 
would  have  had  to  be  provided  otherwise  by  the  stock- 
holders of  the  undertaking.  If  a  portion  of  these  reserves 
had  been  used  to  amortize  a  portion  of  the  stockholders' 
original  investment,  then,  as  these  funds  would  not  be 
available  to  pay  for  extensions,  new  money  would  have 
to  be  obtained  from  the  stockholders.  It  will  be  seen 
from  this  that,  in  all  cases  where  the  property  of  an  under- 
taking is  growing  as  fast  or  faster  each  year  than  the  plant 
cost  divided  by  the  mean  life,  nothing  whatever  is  gained 
by  any  such  plan,  for  by  as  much  as  the  capital  cost  is 
reduced,  by  so  much  must  it  be  restored. 

The  idea  is  interesting,  as  a  study  of  the  working  of  this 
plan  brings  out  very  forcibly  the  association  of  the  public 
in  the  financial  operation  of  a  public  utility.  Every  dollar 
of  the  reserves  for  depreciation  invested  wisely  in  needed 
extensions  results  in  a  reduced  cost  of  service  to  the  public, 
provided  the  public  pays  such  a  reasonable  rate  of  return  that 
new  money,  when  required  for  renewals  or  for  other  pur- 
poses, can  be  obtained  without  undue  difficulty  or  expense. 

If  this  plan  of  amortizing  a  portion  of  the  original 
investment  of  the  stockholders  is  restricted  to  such  under- 
takings only  as  do  not  require  all  of  the  reserves  for 
extensions,  it  is  a  question  whether  a  reserve  fund  would 
not  be  a  wise  provision  to  safeguard  the  public  interests.1 

1  See  Frederick  A.  Delano,  "  The  Application  of  a  Depreciation  Charge  in 
Railway  Accounting,"  The  Journal  of  Political  Economy,  November,  1908. 

Report  of  the  United  Railways  Company  by  the  St.  Louis  Public  Ser- 
vice Commission,  Appendix  A,  by  James  E.  Allison,  p.  75. 

The  Tramway  and  Railway  World,  November  9,  1911. 


CHAPTER  XII 

FAIR  PRESENT  VALUE  — RATES 

145.  Fair  present  value  determined  by  "well-informed"  judgment. 

146.  Two  kinds  of  rate  cases,  —  state  and  court. 

147.  Fair  present  value  dependent  upon  purpose  of  valuation. 

148.  Fair  present  value.     Valuation  for  state  regulation. 

149.  Fair  present  value.     Valuation  for  court  investigation. 

150.  Cost-new  of  property.     State  investigation  of  rates. 

151.  Increased  value  of  real  estate. 

152.  Paving. 

153.  Property  acquired  by  gift.  ^ 

154.  Cost-new  of  property.     Investigation  by  court  of  statutory  rates. 

155.  Increased  value  of  real  estate. 

156.  Cost  of  repaving. 

157.  Property  acquired  by  gift. 

158.  Value  inherent  in  live  plant. 

159.  Brokerage  —  Discounts. 

160.  Tendency  of  later  decisions  to  establish  a  fair  cost-new. 

161.  Depreciation. 

162.  Method  of  figuring  depreciation  in  cases  involving  rates. 

163.  Returns  based  upon  capital  investment. 

164.  Investment  in  property,  not  plant,  ruled  by  courts  as  basis  of  fair 

return. 

165.  Dangers  resulting  from  making  present  value  of  plant  alone  the  basis 

of  fair  rates. 

166.  Valuation  of  new  properties. 

167.  Working  capital. 

168.  Fair  return. 

169.  Fair  rate  based  upon  stock  only  or  upon  stock  and  bonds. 

145.  Fair  present  value  determined  by  "  well-informed  " 
judgment.  —  The  fair  present  value  of  the  property  of  a 
public  utility  is  a  mixed  question  of  fact,  judgment  and 
law  and  the  court  or  commission  is  competent  only  to 
assign  such  value  by  a  judicial  consideration  of  the  facts, 
figures  and  law  involved  in  each  particular  case. 

The  facts  and  figures  required  in  each  case  can  be 
obtained  in  accordance  with  the  methods  which  have  been 


208  PUBLIC  UTILITIES 

described  in  the  preceding  pages.  It  is  futile  to  attempt 
to  formulate  the  decisions  which  have  been  rendered  by 
courts  and  commissions  as  to  fair  present  value,  with 
any  expectation  of  finding  hard  and  fast  rules  upon  which 
such  decisions  have  been  reached.  The  decisions  have 
been  made  by  the  tribunal  upon  well-informed  judgment 
based  upon  the  facts  peculiar  to  each  individual  case. 
Full  justice  can  be  accorded  only  in  this  way. 

The  purpose  of  the  present  work  has  been  accomplished 
if  the  methods  of  obtaining  and  presenting  all  essential 
facts  and  figures  have  been  described  and  formulated  so 
distinctly  and  correctly  that  controversy  as  to  the  accu- 
racy of  the  experts'  figures  may  be  removed  entirely  or  be 
capable  of  adjustment  by  conference,  out  of  court,  between 
those  representing  the  two  sides  of  the  controversy. 

A  full  understanding  of  the  subject  of  valuation  cannot 
be  obtained,  however,  without  some  knowledge  of  the 
general  trend  of  decisions  as  to  true  present  value.  Many 
decisions  have  been  given  without  the  full  knowledge 
which  is  afforded  by  such  figures  as  have  been  described 
above  as  necessary  for  the  use  of  the  tribunal.  In  many 
cases  it  is  extremely  difficult,  if  not  impossible,  to  obtain 
all  of  the  facts  which  influenced  the  decision  in  any  special 
case.  Despite  a  lack  of  sufficient  information  relative  to 
many  of  the  cases  cited,  but  in  order  that  some  knowledge 
of  the  general  trend  of  recent  decisions  may  be  associated 
with  the  present  study,  a  brief  resume*  of  the  court  and 
commission  decisions  is  presented  in  the  following  pages.1 

146.  Two  kinds  of  rate  cases,  —  state  and  court.  - 
In  approaching  a  discussion  of  this  portion  of  the  subject 
of  the  valuation  of  the  properties  of  public  utilities, 
attention  should  be  called  again  to  the  fact  that  rates, 
for  the  service  offered  by  a  utility,  are  regulated  by  the 

1  For  fuller  information  on  this  subject,  see  Public  Service  Corporations 
by  Bruce  Wyman,  191 1 ;  Valuation  of  Public  Utilities  by  R.  H.  Whitten,  1912, 


FAIR  PRESENT  VALUE  — RATES  209 

state  and  that  the  court  does  not  enter  upon  a  considera-^ 
tion  of  the  rates  imposed  until  a  claim  has  been  made 
by  the  undertaking  affected  that  the  rates  are  so  low  as  to 
prevent  it  from  earning  a  proper  return  upon  its  property.  \ 
Thus  it  is  seen  that  there  are  two  authorities  which  may 
enter  into  a  consideration  of  the  schedule  of  rates  of  a 
utility,  the  State  which  has  the  power  of  regulation  and 
the  Court  to  which  appeal  may  be  made  in  case  a  rate 
imposed  by  the  State  appears  to  be  illegal.  The  State, 
in  its  regulation  of  rates,  is  obliged  to  see  that  the  schedule 
of  charges  for  the  utility  furnished  or  for  the  service 
rendered  is  reasonable  and  productive  of  no  more  than 
a  fair  return  upon  the  "  capital  invested  in  good  faith 
and  with  reasonable  judgment"  by  the  undertaking  in 
the  property  in  use  and  useful  to  the  public.  On  the  other 
hand,  the  Court  is  concerned  simply  with  the  question  as 
to  whether  the  earnings  of  the  undertaking,  based  upon 
the  statutory  rate,  are  or  will  be  so  small  as  to  be  virtually 
confiscatory  of  the  property  of  the  undertaking. 

Each  authority,  State  or  Court,  in  all  investigations  as 
to  rates  has  two  things,  therefore,  to  decide,  —  a  rate  of 
return  and  a  value  upon  which  such  return  can  be  earned. 
But  in  each  case  both  figures  may  be  widely  different. 
In  the  case  of  the  State  the  rate  of  return  will  be  that 
which  is  a  fair  reward  for  the  hazard  and  risk  of  those 
investing  in  the  enterprise.  In  the  case  of  the  Court  the 
rate  of  return  may  be  only  that  which  could  be  held  as 
not  so  low  as  to  be  confiscatory.  Again,  the  value  upon 
which  the  undertaking  may  be  entitled  by  the  State  to 
earn  a  return  may  be  only  the  capital  invested  by  the 
undertaking  for  the  use  of  the  public,  whereas  the  value 
of  the  property  assigned  by  the  Court  will  be  based  upon 
the  actual  present  cost  of  reproduction  of  the  entire  prop- 
erty useful  for  the  public. 

147.  Fair  present  value  dependent  upon  purpose  of 


210  PUBLIC  UTILITIES 

valuation.  —  It  is  thus  seen  that  there  are  two  different 
fair  present  values  for  the  same  property,  —  one  value  to 
be  determined  and  used  by  the  State  in  the  regulation  of 
rates  and  another  to  be  determined  and  used  by  the 
Courts  when  a  question  arises  as  to  whether  an  imposed 
rate  is  equivalent  to  a  confiscation  of  the  property  of  the 
undertaking. 

148.  Fair  present  value.    Valuation  for  state  regula- 
tion. —  Strictly  speaking,  the  state  legislature,  a  public 
utility  commission  or  even  the  undertaking  itself  should 
consider  the  fair  present  value,  upon  which  the  schedule 
of  rates  is  to  be  made  so  as  to  yield  a  fair  return,  as  the 
money  which  has  been  expended  in  good  faith  and  with 
reasonable  judgment  in  the  construction  of  the  property 
in  use  and  serviceable  for  the  public  at  the  time  of  the 
investigation  provided  that  value  has  been  maintained 
by  proper  reserves  for  renewals.     The  plant  may  have 
cost  the  undertaking  more  at  the  time  of  construction 
than  it  would  cost  to  build  the  plant  anew  at  the  present 
time;  nevertheless,  the  rates  should  be  based,  theoretically 
at  least,  upon  the  money  legitimately  expended  upon  the 
property  now  in  existence.     Likewise  the  present  value  of 
the  property  may  have  been  greatly  enhanced  by  the 
increased  cost  of  labor  and  material  or  of  real  estate. 
Such  changed  conditions  can  have  no  effect.     It  is  the 
money  which  has  been  expended  for  the  property  in  use 
and  useful,  and  its  value  maintained  by  proper  reserves, 
that  must  be  the  basis  upon  which  the  schedule  of  rates 
should  be  based  by  the  rate  regulating  authorities. 

149.  Fair  present  value.    Valuation  for  court  investiga- 
tion. —  On  the  other  hand,  when  a  question  comes  before 
the  court  as  to  whether  a  rate  or  schedule  of  rates,  imposed 
upon  the  undertaking  by  the  state  rate  regulating  author- 

\  ity,  is  confiscatory  or  not,  the  question  before  the  court  is, 
jwhat  is  the  fair  present  value  of  the  property?    Not 


FAIR  PRESENT  VALUE  — RATES         211 

what  money  was  expended  by  the  undertaking  for  its 
property,  but  rather  what  that  property  then  in  use  and 
useful  is  actually  worth  at  the  present  time.  If  the  plank 
had  cost  more  than  it  would  cost  to-day,  it  makes  no 
difference.  It  is  its  present  value  that  must  be  con- 
sidered. In  a  decision,  Judge  Walter  H.  Sanborn, 
United  States  Circuit  Court,  St.  Paul,  Minn.,  April  8, 
1911,  said: 

"The  just  compensation  secured  by  the  14th  amendment 
entitles  the  defendant  railroad  companies  to  a  fair  return  upon 
the  reasonable  value  of  their  property  in  Minnesota  devoted  to 
the  public  use  of  transportation.  Such  a  return  is  just  to  the 
public  as  well  as  to  the  carriers." 

"Under  the  evidence  in  these  cases  the  cost  of  reproduction 
new  of  the  Minnesota  properties  of  the  defendant  companies 
devoted  to  the  public  use  of  transportation  is  more  persuasive 
evidence  of  their  values  than  the  market  value  of  their  stocks 
and  bonds,  or  the  original  cost  of  their  acquisition  and  con- 
struction." l 

If  the  property  has  depreciated  in  value  due  to  time  of 
service,  such  depreciation  must  be  subtracted  from  the 
replacement  cost.  If  the  schedule  of  rates  yields  a  return 
to  the  undertaking  upon  such  a  fair  present  value  so  low 
as  to  be  confiscatory,  then  the  court  will  find  the  imposed 
rate  illegal.  On  the  other  hand,  if  the  court  finds  the 
present  value  so  small  that  the  imposed  rate  will  yield  a 
return  much  greater  than  the  usual  return  obtained  upon 
similar  property,  the  case  will  be  dismissed,  as  the  question 
before  the  court  is  not  one  of  rate  making  but  as  to  whether 
the  Constitution  of  the  United  States  had  been  violated 
by  the  imposition  of  rates  which  deprive  the  undertaking 
of  its  property. 

150.  Cost-new  of  property.  State  investigation  of 
rates.  —  From  what  was  said  above  it  is  apparent  that 

1  Shepard  v.  Northern  Pacific  Railway  Co.,  184  Fed.  765. 


212  PUBLIC  UTILITIES 

the  main  difference  between  the  fair  value  of  property 
to  be  determined  in  a  rate  investigation  by  state  author- 
ities and  that  to  be  ascertained  by  a  court  will  be  found 
in  the  cost-new  of  the  property.  The  effect  of  the  loss  in 
value  due  to  age  will  be  considered  in  a  later  section. 

Fundamentally,  the  cost-new  to  be  determined  in  the 
case  of  an  investigation  by  the  state  must  be  "the  capital 
invested  in  good  faith  and  with  reasonable  judgment "  by 
the  undertaking,  found  represented  at  the  time  of  the 
valuation  in  plant  in  use  and  useful  to  the  public  plus 
working  capital  and  what  are  frequently  termed  the 
intangible  assets,  i.e.,  value  inherent  in  the  plant  as  a 
part  of  a  well  established  business. 

Considering  for  the  moment  only  that  portion  of  the 
property  represented  by  plant,  the  cost-new  will  be,  as 
nearly  as  can  be  determined,  the  original  cost  of  that 
plant  now  found  in  use  and  useful. 

151.  Increased  value  of  real  estate.  —  If  the  principle 
above  outlined  is  correct,  then  the  increased  value  of  the 
!  real  estate  owned  by  the   undertaking, — the  unearned 
j  increment  which  in  most  cases  is  found  to  exist  in  this 
(  country,  —  cannot  properly  be  included  as  a  portion  of 
the  original  cost.   The  truth  of  this  assertion  will  be  ques- 
tioned and  various  arguments  will  be  raised  to  show  that 
the  unearned  increment  must  be  included  in  any  fair  value 
whether  ascertained  by  court  or  commission  in  a  rate 
case.     Many  court  decisions  may  be  cited  to  substantiate 
the  claim  that  such  increase  in  value  is  a  definite  asset  of 
a  public  utility  upon  which  it  is  entitled  to  a  fair  return. 
Two  cases  only  need  be  cited  bearing  upon  this  question. 

"And  we  concur  with  the  court  below  in  holding  that  the 
value  of  the  property  is  to  be  determined  as  of  the  time  when 
the  inquiry  is  made  regarding  the  rates.  If  the  property, 
which  legally  enters  into  the  consideration  of  the  question  of 
rates,  has  increased  in  value  since  it  was  acquired,  the  com- 
V- 


FAIR  PRESENT  VALUE  — RATES  213 

pany  is  entitled  to  the  benefit  of  such  increase.  This  is,  at  any 
rate,  the  general  rule.  We  do  not  say  there  may  not  possibly 
be  an  exception  to  it,  where  the  property  may  have  increased 
so  enormously  in  value  as  to  render  a  rate  permitting  a  reason- 
able return  upon  such  increased  value  unjust  to  the  public. 
How  such  facts  should  be  treated  is  not  a  question  now  before 
us,  as  this  case  does  not  present  it.  We  refer  to  the  matter 
only  for  the  purpose  of  stating  that  the  decision  herein  does  not 
prevent  an  inquiry  into  the  question  when,  if  ever,  it  should 
be  necessarily  presented."  1 

Another  ruling  on  this  point  is,  "  On  the  other  hand,  however, 
when  property  is  valued  for  the  purpose  last  stated"  (legis- 
lative control),  "it  is  clear  that  the  owner  thereof  is  entitled 
to  the  benefit  of  any  appreciation  in  value  above  the  original 
cost  and  the  cost  of  improvements,  which  is  due  to  what  may 
be  termed  natural  causes.  If  improvements  made  in  the 
vicinity  of  the  property,  the  growth  of  the  city  or  town  where 
it  is  located,  the  building  of  railroads,  the  development  of  the 
surrounding  country,  and  other  like  causes,  give  property 
an  increased  value,  the  owner  cannot  be  deprived  of  such 
increase  by  legislative  action  which  prevents  him  from  realiz- 
ing an  income  commensurate  with  the  enhanced  value  of  his 
property."  2 

Another  argument  in  favor  of  the  inclusion  of  the 
unearned  increment  in  the  value  of  land  has  been  that 
taxes  are  paid  by  the  undertaking  on  this  enhanced  value, 
and  that,  having  to  incur  this  increased  expense,  the 
undertaking  should  be  entitled  to  a  higher  basic  value  for 
its  property.  Or  again,  it  has  been  claimed  that  the 
undertaking  should  be  entitled  to  some  offset,  in  the  way 
of  appreciation  in  the  value  of  its  property,  to  com- 
pensate the  losses  which  may  have  been  incurred  in  the 
early  days  of  its  operation  possibly  with  an  art  but  little 
known. 

The  answers  to  the  last  two  contentions  are  simple. 
Taxes  are  a  portion  of  the  operating  expenses  of  the  com- 

1  Willcox  v.  Consolidated  Gas  Company,  212  U.  S.  52  (1909). 
8  Getting  v.  Kansas  City  Stock- Yards  Co.,  82  Fed.  854. 


214  PUBLIC  UTILITIES 

pany  and,  as  such,  are  paid  by  the  users  of  the  utility 
through  the  rates.  This  being  the  case,  the  imposition  of 
taxes,  based  upon  a  higher  valuation  of  land,  imposes  no 
burden  upon  the  undertaking,  provided  such  taxes  are  con- 
sidered properly  by  the  rate  regulating  authorities  when 
ascertaining  the  current  expenses  of  the  enterprise.  In 
answer  to  the  last  claim,  it  may  be  said  that  early  losses 
should  have  been  cared  for  through  depreciation  reserves 
or,  if  the  earnings  had  been  insufficient  to  make  such 
reserves  possible,  the  early  losses  should  have  been  in- 
cluded in  the  figure  representing  the  value  inherent  in 
the  plant. 

The  answer  to  the  first  contention  is  more  difficult.  A 
strict  adherence  to  the  theory,  which  has  been  set  forth 
above,  demands  that  the  unearned  increment  should  not 
be  included  as  a  portion  of  the  fair  present  value  upon 
which  rates  can  be  based  by  state  authorities.  It  is, 
moreover,  a  legal  question  as  to  how  far  the  cases  above 
cited  are  intended  to  control  the  state  regulating  author- 
ities and  whether  these  and  similar  decisions  have  not 
been  made  rather  from  the  point  of  view  of  a  court  passing 
upon  a  question  of  whether  statutory  rates  were  con- 
fiscatory  or  not. 

It  is  best  to  assume  that  the  theory  is  correct  only  so 
far  as  justice  is  afforded  by  a  strict  adherence  to  it.  The 
fair  present  value  can  be  determined  only  by  "well 
informed  judgment,"  and  the  theory  above  presented  is 
simply  a  guide  as  to  the  direction  which  a  decision  should 
take  provided  it  would  result  in  a  figure  equitable  to  the 
undertaking  and  to  the  public. 

It  would  seem  as  if  the  Massachusetts  Gas  and  Electric 
Light  Commission  had  followed  the  theory  that  the 
unearned  increment  in  land  values  should  not  be  included 
in  cases  of  rate  regulation  as  a  portion  of  the  true  present 
value  of  public  utilities  coming  within  its  control. 


FAIR  PRESENT  VALUE  — RATES  215 

The  Interstate  Commerce  Commission  has  indicated 
its  doubt  as  to  how  far  such  values  should  be  included, 
as  is  instanced  by  the  following  decision. 

"Whatever  the  true  economic  or  legal  view  may  be  as  to  the 
right  of  a  carrier  to  consider  the  increase  in  value  of  its  land 
as  a  part  of  the  value  upon  which  it  is  entitled  to  a  reasonable 
return,  such  increase  in  value  does  not  of  itself  establish  the 
right  of  a  carrier  to  increase  rates  upon  a  given  service.  .  .  . 
It  is  a  conservative  statement  of  the  law  to  hold  that  a  railroad 
may  not  increase  the  rates  upon  a  number  of  commodities 
solely  because  its  real  estate  has  risen  in  value."  1 

On  the  other  hand  the  Wisconsin  Commission  has  used 
quite  generally  the  present  value  of  land  as  a  portion  of  the 
true  present  value  upon  which  rates  should  be  based. 

"In  view  of  these  facts  there  would  seem  to  be  good  ground, 
from  both  a  legal  and  economic  viewpoint,  for  giving  such 
appreciations  in  value  consideration  in  appraising  public 
utilities.  At  any  rate,  we  can  not  now  see  good  reasons  upon 
which  to  exclude  these  elements  from  the  appraisal  of  utility 
properties." 2 

It  is  unnecessary  to  quote  at  greater  length  decisions 
upon  this  point.  A  few  references  bearing  upon  this 
subject  are  given  below.3  In  reading  these  cases  it  is 
important  to  bear  in  mind  that  the  present  value  of  land, 
in  which  necessarily  is  included  the  unearned  increment, 
must  be  used  where  the  case  is  one  of  court  investigation 
as  to  whether  a  rate  imposed  by  state  authorities  is  con- 
fiscatory  or  not.  If  the  decisions  are  studied  with  this 
thought  in  mind,  it  will  be  seen  that  the  logic  of  the  theory 

1  Interstate  Commerce  Commission  Rpts.,  Vol.  XX,  p.  344. 

2  Wis.  R.  R.  Com.  Rpts.,  Vol.  IV,  p.  579. 

3  Consolidated  Gas  Co.  v.  City  of  New  York,  157  Fed.  854;   Willcox 
v.  Consolidated  Gas  Co.,  212  U.  S.  52;   Shepard  v.  Northern  Pac.  R.  R., 
184  Fed.  806;   St.  Louis  Pub.  Serv.  Com.  on  United  Railways  Co.  of  St! 
Louis,  Nov.  19,  1912,  p.  23;  New  York  Pub.  Serv.  Com.,  1st  Dist.,  Deci- 
sions June  23,  1911,  Aug.  18,  1911,  Oct.  20,  1911,  Nov.  17,  1911. 


216  PUBLIC  UTILITIES 

as  to  value  used  by  the  state  authorities  demands  that 
cost  must  be  the  basis. 

I  152.  Paving.  —  The  cost  of  paving  over  that  portion 
of  the  undertaking's  property  placed  in  a  paved  street  or 
under  it,  which  cost  was  not  actually  incurred  by  the 
undertaking,  should  not  be  included  as  a  portion  of  the 
cost-new  in  such  cases  as  are  being  now  considered.  All 
authorities  are  agreed  upon  this  matter.  This  question 
has  been  discussed  already  in  section  28  and  will  be 
treated  later  in  section  156.  Its  exclusion  is  clearly  called 
for  by  the  theory  upon  which  this  study  of  present  value 
is  based. 

153.  Property  acquired  by  gift.  —  Following  strictly 
the  theory  that  an  undertaking  can  earn  only  upon  the 
money  invested  in  property  now  useful  to  the  public,  the 
value  of  all  property,  which  has  been  acquired  by  gift  or 
by  contribution  from  outside  sources,  should  be  excluded 
>  from  the  cost-new  used  in  determining  the  value  upon 
which  rates  should  be  based. 

Conditions  of  this  kind  are  found  very  frequently  in 
the  case  of  railroads  where,  in  many  instances,  grants  of 
land  were  made  by  the  Government  or  State  to  assist  in  the 
construction  of  a  needed  railroad  in  new  country.  Some- 
what the  same  condition  is  present  in  the  aid  given  in  re- 
cent years  by  the  state  or  towns  to  railroads  for  the  elimi- 
nation of  grade  crossings.  Likewise  with  other  classes 
of  utilities,  portions  of  the  plant  may  have  been  paid  for 
by  the  users  in  order  to  obtain  service  under  special  or 
unusual  conditions. 

On  the  other  hand,  utilities  may  have  had  to  incur 
large  expense  upon  property  the  title  to  which  they  do  not 
possess,  in  order  to  meet  the  requirements  of  the  public 
or  public  authorities.  Such  instances  may  be  found 
where  approaches  to  stations  or  changes  in  the  grade  of 
streets  have  been  made  at  the  expense  of  the  undertaking. 


FAIR  PRESENT  VALUE  — RATES  217 

Clearly  such  costs  are  a  portion  of  capital  invested  in  the 
undertaking  and  must  be  included  in  the  value  upon  which 
rates  can  be  earned. 

A  careful  reading  of  all  later  decisions  of  courts  and 
commissions  on  this  subject  seems  to  show  a  general 
recognition  of  the  principle  above  laid  down.  Thus, 

"It  is  well  understood  that,  as  a  matter  of  equity,  the  Com- 
mission does  not  include  services  paid  for  by  consumers  in  the 
valuation  of  public  service  property  for  the  purpose  of  estab- 
lishing rates."  1 

"If  services,"  water  service  pipes,  "are  installed  by  the  util- 
ity, they  constitute  a  part  of  the  plant  upon  which  the  utility 
should  be  allowed  to  earn  a  return  to  provide  for  depreciation 
and  interest;  if  put  in  by  property  owners,  the  cost  of  such 
services  should  not  be  included  in  the  value  upon  which  the 
utility  is  entitled  to  a  return."  2 

154.  Cost-new  of  property.  Investigation  by  court  of 
statutory  rates.  —  Rate  cases  come  before  the  court  for 
a  determination  as  to  whether  rates,  imposed  by  the  rate 
regulating  authorities  of  the  state  upon  the  undertaking, 
are  confiscatory  of  the  property  of  the  undertaking  and, 
consequently,  in  violation  of  the  14th  amendment  of  the 
Constitution  of  the  United  States.  In  such  cases  the 
cost-new  must  be  the  replacement  cost;  and  the  actual 
present  value  must  be  the  replacement  cost  of  the  property 
less  depreciation. 

In  considering  the  figures  derived  to  indicate  the  basis 
of  present  value,  the  court  may  use  original  cost,  capi- 
tal value  of  stocks  and  bonds,  and  even  their  market 
value  as  checks,  however,  only  as  to  the  probable  accu- 

1  City  of  Washburn  v.  Washburn  Water  Works  Co.,  6  Wis.  R.  R.  Com. 
Rpts.,  p.  92   (1910);  See  City  of  Beloit  v.  Beloit  Water,  Gas  &  Elec.  Co., 
7  Wis.  R.  R.    Com.  Rpts.,   215    (1911);    Monheimer  v.  Brooklyn  Union 
Elevated  R.  R.  Co.,  2  P.  S.  C.  1st  Dist.,  N.  Y.  (1910). 

2  Oscar  A.  Alter  et  al.  v.  Ed.  Water  Com.  Manitowoc,  11  Wis.  R.  R., 
p.  387  (1912). 


218  PUBLIC  UTILITIES 

racy  of  the  figure  derived  to  show  the  cost  of  reproduction- 
new. 

In  cases  of  this  kind  it  must  be  value-new  of  the  prop- 
erty, as  of  the  time  of  the  investigation,  in  use  and  useful 
to  the  public  and  not  at  all  the  original  cost,  which  is 
of  importance.  With  this  view  it  is  clear  that  many  of 
the  items  of  value  which  may  have  been  excluded  by  the 
state  authorities  will  be  included  by  the  court.  The 
reasoning  followed  in  sections  151  to  153  relative  to  the 
value  of  real  estate,  of  paving,  and  of  donated  property, 
no  longer  holds  good.  This  difference  in  the  theory  of 
present  value  is  so  important  that  it  will  be  well  to  recon- 
sider these  subjects  in  some  detail. 

155.  Increased  value  of  real  estate.  —  It  is  the  pres- 
ent value  of  the  real  estate,  which  belongs  to  the  under- 
taking, that  should  be  accepted  as  a  definite  asset.     It 
is  the  value  of  the  land  "as  it  is"  that  the  courts  will 
accept  as  the  correct  value.    This  has  been  established 
by  a  long  line  of  court  decisions  which  need  not  be  quoted 
in  detail.1 

156.  Cost  of  repaying.  —  Carrying  out  the  theory  of 
value  above  outlined  it  is  clear  that  what  it  would  cost 
to  replace  the  pavement  over  or  about  the  structures  of  an 
undertaking,  whether  such  pavement  had  been  paid  for 
by  the  undertaking  or  not,  should  be  the  present  value  to 
the  undertaking  of  its  property.     It  is  what  it  would  cost 
at  the  present  time  to  replace  or  reproduce  that  portion 
of  its  plant. 

157.  Property  acquired  by  gift.  —  Here  again  it  is  the 
value  of  the  property  owned   by  the  undertaking,  no 
matter  how  acquired,  that  should  be  given  its  full  present 
value. 

1  Smyth  v.  Ames,  169  U.  S.,  p.  546;  San  Diego  Land  Co.  v.  Nat.  City, 
174  U.  S.,  p.  757;  San  Diego  Land  Co.  v.  Jasper,  110  Fed.  714;  Shepard 
v.  Northern  Pacific  R.  R.,  184  Fed.  806. 


FAIR  PRESENT  VALUE  — RATES  219 

"The  Special  Master  takes  it  to  be  a  sound  principle  of  law 
that  where  property  is  given  to  a  railway  company  for  a 
right  of  way,  such  property  becomes  as  much  a  part  of  the 
property  of  the  railway  company  devoted  to  the  public  use- 
as  does  property  purchased  or  condemned  by  it,  and  its  value  is 
just  as  much  to  be  considered  for  rate  purposes  as  is  the  value 
of  any  other  property  devoted  by  the  railway  company  to  the 
use  of  the  public."  1 

158.  Value  inherent  in  live  plant. — In  cases  before 
a  court  it  would  seem  as  if  logic  demanded  that  it  should 
be  the  cost  of  developing  the  business  anew  as  of  the 
present  time  that  should  be  regarded  as  the  " going  value'7 
of  the  undertaking.     It  cannot  be  past  costs  as  determined 
by  the  Wisconsin  method  (section  61),  but  that  method 
described  in  section  62. 

159.  Brokerage.    Discounts.  --In  the    consideration 
of  replacement  cost  in  section  47,  it  was  stated  that 
the  cost  of  raising  capital,  including  cost  of  brokerage,! 
underwriting  or  discounts,  should  not  be  included  ex-  { 
cept  in  so  far  as  such  items  might  be  effective  in  in- 
creasing the  rate  used  in  figuring  the  loss  of  interest 
during  construction.     This  reasoning  was  based  on  the 
assumption  that  expenses  of  this  character  would  not 
be  capitalized  but  would  be  amortized  through  higher 
rates  of  return. 

This  subject  was  discussed  further  in  connection  with 
original  cost  in  section  81,  wherein  it  was  stated  that 
expenses  of  this  character  should  not  be  included,  for  the 
reason  that  the  par  value  of  securities  was  another  figure 
to  be  presented  to  the  tribunal  and  with  that  figure  and 
the  original  cost  of  the  property  a  full  knowledge  of  the 
difference  between  the  cost  of  the  property  and  par  value 
of  the  securities  could  be  obtained. 

Whether  or  not  these  losses  or  expenses  should  be 

1  Central  of  Georgia  Railway  Co.  v.  Railway  Com.  of  Alabama,  No. 
261,  in  equity,  U.  S.  Middle  Dist.,  Ala. 


220  PUBLIC  UTILITIES 

included  in  the  fair  value  upon  which  rates  should  be 
based  may  depend  somewhat  upon  the  conditions  affecting 
special  cases  but,  speaking  generally,  it  would  seem  as  if 
the  tendency  of  courts  and  commissions  was  to  eliminate 
them  from  the  fair  value,  and  rule  that  all  legitimate 
expenses  of  this  character  should  be  amortized.  This 
does  not  mean  that  the  cost  of  getting  money  is  not  a 
legitimate  portion  of  the  cost  of  the  property,  but  that  it 
is  wiser  to  allow  a  rate  of  return  higher  than  would  other- 
wise have  been  assigned,  and  to  require  that  a  portion  of 
such  return  be  turned  into  a  fund  to  amortize  such  losses. 
Thus  the  expenses  of  this  character  are  made  a  charge 
against  revenue  rather  than  a  portion  of  the  fair  present 
value  of  the  property.1 

This  treatment  as  far  as  the  undertaking  and  the  public 
are  concerned  is  fair  and  just.  It  makes  no  difference  to 
either  whether  a  higher  rate  on  a  lower  capitalization  or 
a  lower  rate  on  a  higher  capitalization  is  allowed.  This 
treatment  avoids  the  more  or  less  theoretical  controversy 
as  to  whether  the  cost  of  raising  money  is  a  portion  of  the 
cost  of  construction  and,  in  consequence,  increases  the 
value  of  the  property  in  use  and  useful  to  the  public. 
That  money,  in  such  quantities  as  are  required  for  most 
public  utilities,  cannot  be  obtained  without  some  expense, 
in  many  cases,  must  be  admitted  and,  if  the  cost  of  such 
money  is  reasonable,  clearly  it  is  only  just  to  the  under- 
taking that  it  should  recover  the  legitimate  expenses  to 
which  it  has  been  put  in  providing  the  public  with  a  needed 
service.  But  that  the  cost  of  obtaining  money  with  which 
to  construct  a  property  increases  the  value  of  that  property 
appears  to  be  considered  by  most  rate  making  bodies  in 
this  country  as  questionable. 

Thus,  "If  rate-making  is  to  be  based  upon  actual  cost,  it  would 

seem  that  such  cost  must  be  measured  by  the  money  necessa- 

i  See  N.  Y.  P.  S.  C.,  1st  Disk,  Case  No.  1305  (Dec.  10,  1912). 


FAIR  PRESENT  VALUE  — RATES  221 

rily  expended  in  producing  the  construction  without  regard  to 
whether  those  undertaking  the  enterprise  have  the  same  or  must 
borrow  for  the  purpose  —  a  matter  in  which  the  public  has  no 
concern.  If  allowed  interest  during  construction  on  the  money- 
invested,  more  should  not  be  asked;  otherwise,  the  rate  would 
be  directly  affected  by  the  good  credit  or  otherwise  of  those 
undertaking  the  work."  1 

On  the  other  hand,  in  the  decision  in  the  case  of  sale  of 
National  Telephone  Company  to  the  Postmaster  General 
of  England,  Mr.  Justice  Lawrence  said : 

"  Whoever  raises  the  money  necessary  to  pay  for  the  materials, 
labour,  &c.,  &c.,  is  put  to  the  expense  of  raising  that  money. 
Every  necessary  cost  must  appear  in  value,  otherwise  no  sane 
person  would  ever  knowingly  construct;  for,  if  it  does  not 
appear  in  value,  it  must  result  in  loss,  and  to  say  it  should  be 
relegated  to  loss  is  to  deny  the  principle  upon  which  we  are 
agreed,  that  value  should  be  ascertained  by  finding  what  it 
would  cost  to  construct  the  plant.  Unless,  then,  it  can  be 
affirmed  that  money,  unlike  other  commodities,  can  be  pro- 
cured without  expense,  it  is  clear  that  this  item  must  be  included 
at  its  proper  amount.  In  other  words,  we  must  either  refuse 
to  follow  the  formula  approved  by  the  House  of  Lords  and 
agreed  to  by  the  parties,  or  find,  as  a  fact,  that  money  can  be 
procured  for  nothing."  2 

In  a  dissenting  opinion  in  the  same  case,  Sir  James 
Woodhouse  said: 

"The  cost,  therefore,  of  the  thing  constructed  must,  by  the 
hypothesis,  differ  according  to  whether  a  man  has  to  pay  for 
raising  the  money,  or  is  in  a  position  to  find  it  without  incurring 
that  expense.  I  fail  utterly  to  see  how  this  can  be  right,  when 
we  bear  in  mind  that  cost  is  only  material  as  a  step  to  ascertain 
the  value  of  what  is  constructed.  It  is,  in  fact,  making  the 

1  Report  Special  Master  in  Chancery,  Sept.  21,  1910,  Shepard  v.  No. 
Pacific  R.  R.,  184  Fed.  764  (1911). 

2  Decision  Mr.  Justice  Lawrence,  The  Nat.  Tel.  Co.,  Ltd.  v.  H.  M . 
Postmaster  General  (1913). 


222  PUBLIC  UTILITIES 

value  of  the  thing  constructed  vary  with  and  be  dependent  on 
the  financial  ability  or  credit  of  the  constructor."  1 

It  would  seem  that,  even  in  a  case  of  sale,  the  exclu- 
sion of  the  cost  of  raising  capital  from  the  fair  value  was 
wise  and  just  provided  the  rate  regulating  authorities 
recognized  that  rates  should  be  maintained  sufficiently 
high  to  amortize  such  cost  within  a  resonable  time.2 

160.  Tendency  of  later  decisions  to  establish  a  fair 
cost-new.  —  In  what  has  been  said  above  an  attempt  has 
been  made  to  state  somewhat  absolutely  the  fundamental 
principles  which  underlie  valuations  and  to  show  what 
values  may  be  expected  if  these  fundamental  principles  of 
valuation  are  rigidly  carried  out.  In  early  cases  bearing 
upon  rates,  the  courts  unquestionably  adhered  to  the 
doctrine  that  the  province  of  the  court  was  simply  to 
determine  whether  statutory  rates  were  confiscatory  or 
not.  In  later  years  state  commissions  have  been  formed, 
composed  of  men  capable  of  careful  analysis  of  all  factors 
affecting  value.  These  commissions,  in  most  cases,  have 
determined  value  not  along  the  lines  of  a  rigid  or  arbi- 
trary theory,  such  as  has  been  outlined  above,  but 
"with  the  well  informed  judgment"  with  which  the  courts 
have  said  the  determination  of  present  value  should  be 
made. 

The  result  has  been  that  the  figures  derived  by  commis- 
sions have  not  been  strictly  original  cost  but  figures  which 
under  all  of  the  special  conditions  of  each  particular  case 
seemed  to  them  to  be  fair.  They  have  taken  the  several 
sets  of  figures  which  have  been  described  in  the  preceding 
pages  and  determined  what  in  their  judgment  might  be 
considered  a  figure  which  would  be  fair  to  the  undertaking 

1  Dissenting  opinion   Sir  James  Woodhouse,  The  Nat.  Tel.  Co.,  Ltd. 
v.  H.  M.  Postmaster  General  (1913). 

2  For  possible  exceptions  to  this  doctrine  see  reports  Wisconsin  Com- 
mission. 


FAIR  PRESENT  VALUE  — RATES  223 

and  to  the  public.  Some  commissions  have  gone  still 
further  than  this  and  have  used  cost  of  reproduction-new 
rather  than  original  cost  as  the  basis.  Thus  in  a  recemV 
decision  a  commission  said, 

"We  do  not  think  that  the  original  cost  of  construction, 
whatever  that  may  have  been,  ...  is  a  proper  standard  to 
determine  the  value  of  the  plant  and  equipment  for  which  the 
company  is  entitled  to  receive  a  fair  income,  but  that  the  cost 
of  reproduction  at  the  present  time  in  this  particular  case  is  a 
more  accurate  standard."  1 

Likewise  the  tendency  of  the  courts  has  been  to  depart 
from  the  strict  question  as  to  what  the  value  of  the  prop- 
erty was  and  what  rate  would  be  confiscatory  but,  re- 
cognizing the  work  of  the  commissions,  to  review  their 
decisions  as  to  a  figure  fair  to  both  parties  affected. 

Courts  have  given  of  late  decisions  defining  fair  rates  of 
return.  If  this  practice  is  to  be  continued,  clearly  the  basis 
of  fair  value  will  be  changed  and  courts  and  commissions 
will  adopt  a  basis  of  fair  value  in  many  cases  probably 
somewhere  between  the  original  cost  and  cost-new  as  of 
the  present  time. 

Thus  in  course  of  time  conventions  or  rules  may  grow 
up  as  to  what  may  or  may  not  be  included  in  the  fair 
present  value.  Thus  the  cost  of  repaving  seems  to  be 
almost  universally  excluded.  The  present  value  of  land 
rather  than  original  cost  seems  to  be  recognized  in  cases 
where  the  unearned  increment  is  not  so  large  as  to  affect 
rates  unduly. 

161.  Depreciation.  —  The  courts  have  held  that  "what 
the  company  is  entitled  to  demand  in  order  that  it  may 
have  just  compensation  is  a  fair  return  upon  the  reasonable 
value  of  the  property  at  the  time  it  is  being  used  by  the 
public/' 

1  Conn.  Pub.  Utilities  Com.,  Pet.  H.  O.  Bowers  et  al.,  March  7,  1912. 


224  PUBLIC  UTILITIES 

The  investment  in  a  portion  or  the  whole  of  the  physical 
property  of  the  undertaking  will  have  depreciated  in 
value  due  to  its  years  of  service  and  consequently,  at  the 
time  of  the  appraisal,  have  a  value  less  than  the  fair 
value-new  whatever  that  figure  may  have  been  found  to 
be.  The  depreciation  which  the  plant  has  suffered  must 
be  presented  in  such  form  that  the  court,  having  deter- 
mined the  reasonable  value  of  the  plant  new,  can  find  the 
reasonable  value  of  the  property  as  it  exists  at  the  time 
of  the  appraisal. 

162.  Method  of  figuring  depreciation  in  cases  involving 
rates.  —  In  the  last  chapter,  two  methods  of  figuring  the 
loss  in  the  value  of  a  property  were  described.  One,  the 
so-called  straight  line  method,  was  held  to  be  applicable 
to  such  cases  as  plant  alone  formed  the  property  of  the 
undertaking,  and  the  second,  the  sinking  fund  method, 
when  the  property  consisted  both  of  plant  and  of  reserves 
invested  in  outside  securities. 

As  stated  in  the  last  section,  the  undertaking  is  entitled 
to  a  fair  return  upon  the  reasonable  value  of  the  property 
at  the  time  it  is  being  used  by  the  public.  It  is  necessary 
now  to  see  whether  these  two  methods  of  determining  loss 
of  value  will  operate  equitably  in  all  cases. 

As  was  demonstrated  in  section  137,  if  there  is  plant 
alone  as  representative  of  the  property  of  the  undertaking, 
the  straight  line  method  when  age  and  life  have  been 
determined  with  accuracy  will  show  the  absolute  loss  in 
value  and,  consequently,  this  loss  in  value  gives  the  true 
depreciation  of  the  property. 

If  the  property  of  the  undertaking  consists  of  plant  and 
reserves,  the  sinking  fund  method  will  likewise  show  the 
loss  in  value  if  properly  applied.  But  the  equity  of  this 
method  has  been  the  subject  of  much  doubt.  It  has  been 
argued  that,  if  the  straight  line  method  is  proper  for  use 
when  applied  to  property  consisting  of  plant  alone,  it 


FAIR  PRESENT  VALUE  — RATES  225 

should  always  be  applied  to  the  valuation  of  plant  even 
when  associated  with  reserves.  Thus,  if  a  plant  having 
a  fan*  cost-new  of  $100,000,  was  being  valued  at  the  endr 
of  5  years  of  a  10-year  life,  and  the  property  of  the  under- 
taking was  found  to  consist  of  the  plant  and  outside  secu- 
rities to  the  amount  of  $46,312,  drawing  3  per  cent  interest, 
it  would  be  argued  that  the  plant  by  the  straight  line 
method  would  be  worth  $50,000,  and  the  securities 
$46,312,  so  that  the  present  value  of  the  property  was 
$96,312,  and  upon  that  sum  alone  the  undertaking  was 
entitled  to  base  its  return.  Such  a  line  of  reasoning  is 
manifestly  unfair  to  the  undertaking.  The  company  has 
done  all  that  its  duty  to  the  public  demands,  in  that  it  has 
made  reserves  sufficient  to  ensure  to  the  public  the  con- 
tinuation of  the  service;  it  has  exacted  from  the  public  as 
small  payments  to  the  reserves  as  could  be  made  and,  at 
the  same  time,  guarantee  a  continuation  of  the  operation 
of  the  property.  If  the  undertaking  is  to  be  thus  penal- 
ized by  a  reduction  of  its  assets  below  what  it  has  actually 
invested,  recourse  would  have  to  be  made  to  larger  reserves 
for  depreciation  at  the  early  years  of  the  operation  of  the 
plant,  and  gradually  reduced  annual  payments,  in  order 
thus  artificially  to  make  the  reserves  conform  to  the  loss 
in  value  produced  by  the  straight  line  method  applied  to 
the  plant.  Rates  cannot  be  changed  each  year.  By  the 
use  of  the  sinking  fund  method  as  thus  outlined  the  rates 
would  remain  unchanged  throughout  the  life  of  the  plant 
and  even  after  it  was  renewed,  as  the  capitalization,  i.e., 
the  value  of  the  property,  would  remain  unchanged. 

But  in  the  case  of  depreciation  as  in  all  other  matters 
relating  to  valuations,  arbitrary  rules  cannot  be  applied. 
The  choice  of  which  method  should  be  used  to  ascertain 
depreciation  will  depend  upon  the  good  judgment  of  those 
whose  duty  it  is  to  make  the  decision.  Thus  cases  can 
be  conceived  wherein  a  rigid  adherence  to  the  rule  of  using 


226  PUBLIC  UTILITIES 

the  straight  line  method  for  property  consisting  of  plant 
alone,  and  the  sinking  fund  method  for  plant  associated 
with  reserves,  would  prove  inequitable  to  the  undertaking. 
Thus  if,  in  the  case  cited  above,  the  reserves  had  been 
$100  instead  of  being  $46,312,  then,  since  there  are  re- 
serves in  hand,  if  this  rule  is  followed  the  loss  in  value  must 
be  ascertained  by  the  sinking  fund  method.  $100  at 
compound  interest  for  five  years  would  be  approximately 
$116.  The  accumulations  of  the  annuity  and  interest  at 
the  end  of  five  years  on  $100,000  at  a  three  per  cent  rate 
is  $46,312.  Thus,  by  a  strict  adherence  to  the  above  rule, 
the  loss  in  value  would  be  $53,572;  whereas  it  would  have 
been  fairer  to  the  undertaking  in  such  a  case  to  have  used 
the  straight  line  method. 

163.  Returns  based  upon  capital  investment.  —  The 
theory  of  depreciation,  which  has  been  outlined  in  the 
preceding  pages,  is  founded  on  the  belief  that  justice  to 
the  public  and  to  the  undertaking  can  be  obtained  only 
when  the  fair  value  upon  which  rates  can  be  based  is 
ruled  to  be,  as  nearly  as  may  be  capable  of  determination, 
the  proper  investment  of  shareholders  in  the  enterprise 
(neglecting  for  the  present  any  question  of  the  unearned 
increment),  provided  there  is  always  maintained  that 
value  by  adequate  reserves  to  make  good  the  loss  in  the 
value  of  the  investment  arising  from  the  years  of  service. 

But,  it  has  been  contended,  the  courts  have  held  that 
rates  shall  be  based  on  "the  present  value  of  the  property 
of  the  undertaking  in  use  and  useful  to  the  public"  and 
not  the  cost  of  the  property.  The  answer  to  this  conten- 
tion is  that  it  is  a  question  of  property,  not  plant  alone, 
and  of  property  maintained  through  adequate  reserves 
at  that  value. 

But  again  it  is  argued,  if  that  theory  is  correct  the 
plant  value  may  be  a  fraction  of  the  cost,  and  the  full  cost 
be  attained  only  by  adding  to  the  plant  value  the  reserves 


FAIR  PRESENT  VALUE  — RATES  227 

for  depreciation.  On  such  a  basis  the  public  would  have 
to  pay  a  return  not  only  on  the  plant  value  but  upon  the 
depreciation  reserves  which  possibly  may  be  drawing 
interest  from  some  outside  source.  The  plant  is  in  use 
and  useful  to  the  public ;  the  reserves  are  not.  It  cannot 
be  right  to  make  the  public  pay  a  return  upon  depreciation 
reserves  which  it  has  contributed  to  the  undertaking. 

These  arguments  cannot  be  held  to  be  sound.  If  all 
reserves  are  invested  in  plant,  the  method  which  has  been 
described  clearly  determines  a  value  upon  which  rates  are 
to  be  based,  which  does  not  include  the  plant  purchased 
with  such  reserves.  If  the  property  consists  of  plant  and 
money  properly  invested,  the  value  of  the  property  is  that 
sum  which  can  be  proved  to  be  capable  of  use  for  the 
benefit  of  the  public.  The  very  fact  that  the  plant  is  to 
be  used  only  as  long  as  it  affords  good  service  and  will  be 
renewed  with  funds  held  specially  for  that  purpose  main- 
tains the  full  value  of  the  investment  in  perishable  prop- 
erty. Nor  does  the  public  pay  a  return  upon  the  reserves; 
it  pays  a  return  upon  the  property  as  a  whole  which  is 
held  and  used  for  the  benefit  of  the  public.  The  interest 
on  the  reserve  funds  does  not  go  to  swell  the  returns  to 
the  stockholders  but  is  used  to  reduce  the  aniount  which 
the  public  has  to  pay  toward  the  depreciation  reserves. 

164.  Investment  in  property,  not  plant,  ruled  by  courts 
as  basis  of  fair  return.  —  The  Supreme  Court  has  said, 
"It"  (an  undertaking)  "is  entitled,  it  is  its  duty,  to  see 
that  from  its  earnings  the  value  of  the  property  invested  is 
kept  unimpaired,  so  that,  at  the  end  of  any  given  term  of 
years,  the  original  investment  remains  as  it  was  at  the  be- 
ginning." It  must  be  noted  that  the  court  says  that  it  is 
the  value  of  the  property,  not  value  of  the  plant.  This 
ruling  of  the  Supreme  Court  states  as  clearly  and  defi- 
nitely as  words  can  express,  that  the  sums  set  aside  from 
earnings  keep  the  property  invested  unimpaired.  Another 


228  PUBLIC  UTILITIES 

ruling  of  the  Supreme  Court  is  that  it  is  "the  fair  value  of 
the  property  being  used  by  it  for  the  convenience  of  the 
public/7  that  must  be  the  basis  of  all  calculations  as  to 
the  reasonableness  of  rates.  In  the  light  of  these  rulings, 
it  must  be  property,  the  property  invested  and  kept 
unimpaired  by  depreciation  reserves,  property  invested  by 
the  stockholders  in  the  undertaking  and  held  by  the  un- 
dertaking for  the  perpetuation  of  the  service  to  the  public, 
that  must  be  the  basis  for  all  calculations  as  to  the  reason- 
ableness of  rates.  It  is  illogical  and  unreasonable  to  ex- 
pect that  the  court  will  hold  that,  if  the  value  of  the  plant 
diminishes  year  by  year,  the  return  to  the  stockholders 
must  diminish  correspondingly,  and  be  increased  when 
the  reserves  for  depreciation  properly  set  aside  bring  back 
to  the  plant  its  original  cost.  It  is  the  investment  in  prop- 
erty that  is  the  basis  of  fair  rates  and  the  depreciation  re- 
serves hold  the  value  of  the  investment  unchanged.  In 
other  words,  the  depreciation  reserves  are  a  part  of  the 
property  of  the  undertaking,  as  much  as  is  the  plant  itself. 
In  another  case  the  court  has  said : 

"It  was  obligatory  upon  the  complainant  to  show  that  no  part 
of  the  money  raised  to  pay  for  depreciation  was  added  to  cap- 
ital, upon  which  a  return  was  to  be  made  to  stockholders  in 
the  way  of  dividends  for  the  future.  It  cannot  be  left  to  con- 
jecture, but  the  burden  rests  with  the  complainant  to  show 
it.  It  certainly  was  not  proper  for  the  complainant  to  take 
the  money,  or  any  portion  of  it,  which  it  received  as  a  result  of 
the  rates  under  which  it  was  operating,  and  so  to  use  it,  or  any 
part  of  it,  as  to  permit  the  company  to  add  it  to  its  capital 
account,  upon  which  it  was  paying  dividends  to  shareholders. 
If  that  were  allowable,  it  would  be  collecting  money  to  pay  for 
depreciation  of  the  property,  and,  having  collected  it,  to  use 
it  in  another  way,  upon  which  the  complainant  would  obtain 
a  return  and  distribute  it  to  its  stockholders.  That  it  was 
right  to  raise  more  money  to  pay  for  depreciation  than  was 
actually  disbursed  for  the  particular  year  there  can  be  no  doubt, 
for  a  reserve  is  necessary  in  any  business  of  this  kind,  and  so 


FAIR  PRESENT  VALUE  — RATES  229 

it  might  accumulate,  but  to  raise  more  than  money  enough  for 
the  purpose  and  place  the  balance  to  the  credit  of  capital  upon 
which  to  pay  dividends  cannot  be  proper  treatment."  1 

This  decision  seems  to  establish  the  principle  that  it 
is  the  value  of  the  property  in  which  the  stockholders  of 
the  undertaking  have  invested  their  money,  which  prop- 
erty has  been  kept  unimpaired,  that  is  the  basis  of  fair 
rates. 

165.  Dangers  resulting  from  making  present  value 
of  plant  alone  the  basis  of  fair  rates.  —  One  more  point 
only  will  be  cited  to  show  that  the  depreciation  reserves 
not  invested  in  plant  must  be  included  as  a  portion  of 
the  value  of  the  property  of  an  undertaking  upon  which 
rates  should  be  based.     If  the  depreciation  reserves  are 
to  be  excluded  from  the  property  of  an  undertaking,  it 
would  be  necessary  for  all  undertakings  to  invest  all 
their  reserves  in  extensions  to  their  property  whether 
there  was  a  need  of  such  extensions  or  not.     In  very 
many  cases  where  the  growth  of  a  community  is  slow  or 
the  financial  success  of  the  undertaking  is  doubtful,  it 
may  be  wiser  to  safeguard  the  reserves  by  holding  them 
in  good,  readily  convertible  securities. 

166.  Valuation  of  new  properties.  —  In   some   cases 
it  may  be  necessary  to  make  a  valuation  of  a  property 
before  it  has  been  in  operation  long  enough  to  have  ob- 
tained a  sufficient  income  to  pay  its  operating  expenses, 
to  make  proper  and  sufficient  contributions  to  its  depre- 
ciation reserves  and  to  contribute  a  proper  return  to  its 
stockholders.     In  such  a  case,  in  one  state  at  least,  the 
Public  Service  Commission  has  authority  to  permit  a  tem- 
porary abandonment  of  depreciation  reserves,  and  the  loss 
properly  sustained  may  be  considered  as  a  part  of  the 
value  of  the  property  incident  to  making  it  a  going  con- 

1  Louisiana  R.  R.  Com.  v.  Cumberland  Tel.  &  Teleg.  Co.  212  U.  S. 
424  (1909). 


230  PUBLIC  UTILITIES 

cern.  In  such  a  case  the  present  value  will  be  something 
more  than  the  original  cost  or  the  replacement  cost  plus 
other  proper  intangible  assets  and  must  be  found  by  a 
study  somewhat  similar  to  that  of  the  artificial  de- 
termination of  going  value  as  a  part  of  the  cost  of 
developing  the  business. 

167.  Working  capital.  —  Nothing  has  been  said  up  to 
the  present  time  relative  to  working  capital,  which  is 
naturally  an  asset  of  any  large  undertaking  and  is  essen- 
tial to  the  successful  and  economical  operation  of  its 
business.  This  item  has  been  omitted  for  the  reason 
that  it  does  not  enter  naturally  as  a  portion  of  the  ap- 
praisal but  is  a  sum  which  must  be  obtained  directly 
from  the  books  of  the  undertaking. 

The  items  to  be  included  in  working  capital  are  supplies 
of  all  kinds,  cash  for  current  use  in  sufficient  amounts 
to  insure  economical  and  safe  operation  of  the  plant,  and 
the  balance  between  bills  and  accounts  receivable  and 
accounts  payable. 

"  Plants  which  are  running,  or  in  actual  operation,  must 
have  working  capital  as  well  as  fixed  capital.  In  this  case 
the  latter,  or  the  fixed  capital,  is  largely  represented  by  the  cost 
of  reproducing  the  plants,  while  the  working  capital  is,  in  part, 
represented  by  the  figures  given  in  that  table  for  '  stores  and 
supplies/  The  stores  and  supplies  there  given,  however,  do 
not  represent  all  the  working  capital  the  plants  require.  Plants 
of  this  kind,  the  same  as  practically  all  other  business  enter- 
prises, must  have  on  hand  a  reasonable  cash  balance  and  other 
current  resources  in  order  to  operate  economically  and  effec- 
tively. That  this  is  the  case,  is  almost  self-evident.  Just 
what  sum  represents  a  fair  amount  for  working  capital,  is  nearly 
always  a  matter  of  judgment,  and  to  this  there  is  no  exception 
in  this  case." l 

The  proper  amount  to  be  allowed  for  working  capital 
must  be  decided  for  each  particular  case  as  it  arises,  by 
*  Wis.  R.  R.  Com.  Rpts.,  Vol.  5,  p.  316. 


FAIR  PRESENT  VALUE  —  RATES  231 

a  consideration  of  the  character  and  extent  of  the  opera- 
tions of  the  undertaking,  the  working  capital  ordinarily 
carried  by  it  in  the  past,  and  the  amounts  usually  car- 
ried by  similar  undertakings  of  the  same  size  and  activity. 
Probably  the  best  citation  of  a  court  ruling  on  this 
item  will  be  a  portion  of  the  opinion  of  the  Court  in  the 
case  of  the  Consolidated  Gas  Company  v.  City  of  New 
York. 

"The  amount  of  cash  necessary  for  the  safe  and  convenient 
transaction  of  a  business,  having  regard  to  the  owner's  ordi- 
nary outstandings  both  payable  and  receivable,  the  ordinary 
condition  of  his  stock,  or  supplies  in  hand,  the  natural  risk  of 
his  business,  and  the  condition  of  his  credit;  and  unless  these 
matters,  and  perhaps  others,  be  looked  into,  no  comparison 
can  be  drawn  between  one  business  and  another,  or  even  be- 
tween those  of  the  same  general  nature."  1 

168.  Fair  return.  —  There  may  be  two  figures  which 
may  be  assigned  as  the  return  which  a  public  utility  can 
earn  upon  the  fair  present  value  of  its  property,  —  one  a 
rate  assigned  by  the  state  authorities  as  a  fair  return, 
when  the  hazards  and  risks  incurred  by  the  undertaking 
are  considered,  as  well  as  the  rate  of  return  to  similar 
enterprises  in  the  same  or  similar  localities;  the  other, 
a  rate  assigned  by  the  court  as  productive  of  such  a 
return  as  would  not  be  considered  confiscatory  of  the 
property. 

Authority  for  fair  rate  of  return  allowed  by  the  state 
can  be  summed  up  best  by  the  following  decisions. 

"It  therefore  does  not  seem  that  rates  producing  no  more 
than  a  reasonable  return  on  their  fair  value  could  be  unjust  to 
any  one.  In  fixing  the  measure  of  return  upon  property 
devoted  to  public  use  regard  should  be  had  to  the  character 
of  the  business,  the  locality  and  the  risk ;  whether  the  return 
will  be  uniform  and  secure;  whether  the  patronage  is  steady  or 

1  Consolidated  Gas  Co.  v.  City  of  N.  Y.,  157  Fed.  859  (1907). 


232  PUBLIC  UTILITIES 

fluctuating  and  quickly  responsive  to  financial  and  commer- 
cial changes;  interest  rates  legal  and  contractual  and  the  rates 
customarily  sought  and  required  in  like  investments  in  the 
locality;  if  a  railroad,  the  character  of  the  traffic,  whether 
largely  of  a  kind  dependent  upon  uncertain  conditions,  or  so 
diversified  that  causes  affecting  part  will  not  greatly  affect  the 
whole.  The  return  should  be  a  fair,  just,  and  reasonable  one, 
and  not  so  meager  as  to  repel  investment  in  the  property  or  to 
embarrass  the  owner  in  operating  it."  1 

"There  is  no  particular  rate  of  compensation  which  must  in 
all  cases  and  in  all  parts  of  the  country  be  regarded  as  sufficient 
for  capital  invested  in  business  enterprises.  Such  compensa- 
tion must  depend  greatly  upon  circumstances  and  locality; 
among  other  things,  the  amount  of  risk  in  the  business  is  a 
most  important  factor,  as  well  as  the  locality  where  the  busi- 
ness is  conducted  and  the  rate  expected  and  usually  realized 
there  upon  investments  of  a  somewhat  similar  nature  with 
regard  to  the  risk  attending  them.  There  may  be  other  mat- 
ters which  in  some  cases  might  also  be  properly  taken  into 
account  in  determining  the  rate  which  an  investor  might 
properly  expect  or  hope  to  receive  and  which  he  would  be 
entitled  to  without  legislative  interference.  The  less  risk, 
the  less  right  to  any  unusual  returns  upon  the  investments."  2 

A  court,  when  a  question  arises  as  to  a  fair  rate  of 
return,  may  not  "  undertake  to  guarantee  the  company 
any  fixed  or  certain  return  upon  its  investment"  or  even 
say  what  a  fair  return  might  be,  but  may  rather  say 
whether  a  certain  rate  is  so  low  as  to  be  deemed  by  it 
confiscatory  of  the  property  of  the  company.  There 
seems  to  be  no  doubt  that,  if  the  principle  above  outlined 
is  followed,  the  court  might  rule  that  the  undertaking  has 
a  right  to  a  gross  revenue  such  that  it  can  pay  all  legiti- 
mate operating  expenses,  pay  interest  on  all  valid  fixed 
charges,  so  far  as  bonds  or  securities  represent  an  expend- 
iture actually  made  in  good  faith,  and,  if  the  return  upon 
the  stock  is  equal  to  that  which  is  obtained  from  a  govern- 

1  Missouri,  Kansas  &  Texas  Ry.  Co.  v.  Love,  177  Fed.  502  (1910). 

2  Willcox  v.  Consolidated  Gas  Co.,  212  U.  S.  48  (1909). 


FAIR  PRESENT  VALUE  — RATES  233 

ment  bond,  for  instance,  the  rates  producing  such  gross 
revenue  could  not  be  considered  confiscatory. 

That  such  an  extremely  low  rate  should  not  be  consid- 
ered confiscatory  would  seem  to  impose  an  unfair  burden 
upon  the  public  utility,  in  view  of  the  special  hazards 
incurred  by  such  enterprises.  But  on  the  other  hand 
it  must  be  recognized  that  such  a  low  rate  of  return  may 
be  figured  upon  a  cost-new  in  which  there  has  arisen 
possibly  an  extremely  large  unearned  increment. 

Attention  should  be  called  to  the  fact,  however,  that 
as  with  fair  value,  though  possibly  to  a  lesser  degree, 
the  courts  have  receded  in  many  later  decisions  from  the 
theoretical  requirements  above  outlined  and  have  either 
confirmed  the  fair  returns  assigned  by  state  authorities 
or  have  decided  what  a  fair  return  should  be  under  the 
conditions  peculiar  to  each  particular  case. 

169.  Fair  rate  based  upon  stock  only  or  upon  stock 
and  bonds.  —  An  undertaking  is  entitled  to  a  fair  return 
upon  the  value  of  the  property  in  use  and  useful  to  the 
public.  A  fair  return  has  been  ruled  to  be  in  many  cases 
a  percentage  varying  between  5  and  8  per  cent.  The 
question  then  arises  as  to  whether  this  fair  rate  of  return 
shall  apply  to  the  entire  value  of  the  property  or  only  to 
the  stockholders'  investment.  In  most  cases  the  property 
has  been  created  by  money  received  from  the  sale  of 
bonds  as  well  as  from  money  paid  in  by  stockholders.  If 
equal  amounts  were  received  from  these  two  sources  and 
the  bonds  bore  interest  at  a  rate  lower  than  the  rate  ruled 
by  the  rate  making  authorities  as  fair,  then  the  stock- 
holders would  receive  a  return  greater  than  the  fair  rate 
for  the  property  as  a  whole. 

Thus,  as  an  example,  a  question  may  arise  as  to  what 
percentage  return  can  be  paid  by  an  undertaking  to  its 
stockholders,  where  the  rate  regulating  authorities  have 
decided  that  the  fair  present  value  of  its  property  is 


234  PUBLIC  UTILITIES 

$1,000,000  and  that  the  fair  rate  of  return  is  8  per  cent. 
The  undertaking  has  paid  for  its  property  by  the  issue  of 
four  per  cent  bonds  to  the  value  of  $500,000  and  by  the 
sale  of  stock  of  a  value  of  $500,000.  The  undertaking 
cannot  say  that  it  is  entitled  to  earn  $80,000  a  year,  so 
that,  after  paying  the  interest  on  the  bonds  amounting 
to  $20,000,  the  remaining  $60,000  can  be  paid  as  a  twelve 
per  cent  dividend  to  the  stockholders.  The  fair  return, 
in  this  example  8  per  cent,  is  to  be  figured  upon  the  amount 
actually  invested  by  the  stockholders  in  the  enterprise. 


CHAPTER  XIII 

FAIR  PRESENT  VALUE  —  CONDEMNATION  OR  SALE 

170.  Market  value. 

171.  Fair  cost-new. 

172.  Increased  cost  of  maintenance. 

173.  Uncertainty  as  to  life. 

174.  Value  of  franchise. 

175.  Depreciation  in  cases  of  sale. 

176.  Investment  of  buyer  must  be  full  cost-new  of  a  public  utility  prop- 

erty. 

177.  Present  value  in  case  of  sale. 

170.  Market  value.  —  The  methods  of  determining 
fair  present  value,  which  have  been  described  in  the 
preceding  pages,  are  those  which  apply  in  cases  of  rate 
regulation  in  the  case  of  a  utility  which  is  to  continue  to 
furnish  the  service  to  the  public.  The  question  next  to 
be  discussed  is  whether  the  same  methods  are  applicable 
when  it  is  required  to  determine  the  fair  present  value  in  a 
case  involving  the  condemnation  or  sale  of  the  property 
of  a  public  utility. 

The  principle  underlying  the  sale  of  an  ordinary  com- 
modity is  that  the  fair  price  is  such  a  sum  of  money  as 
would  be  paid  by  a  willing  buyer,  having  the  necessary 
funds,  to  a  willing  seller.  In  the  case  of  the  sale  of  a  pub- 
lic utility  undertaking,  this  same  principle  holds  good,  ex- 
cept that  there  is  introduced  the  interests  of  a  third  party 
or  group,  the  users  of  the  utility  or,  as  it  will  be  termed, 
the  public.  The  rights  of  the  public  must  be  conserved 
by  such  a  regulation  of  the  price  paid  that  the  amounts, 
which  must  be  paid  by  the  public  in  the  form  of  rates 
for  the  use  of  the  service  and  for  its  continuation,  —  de- 
preciation reserves,  —  must  not  be  enhanced.  The  fair 


236  PUBLIC  UTILITIES 

present  value  of  the  property  of  a  public  utility  under- 
taking in  a  case  of  sale,  therefore,  must  be  such  a  price 
as  is  fair  to  the  public  as  well  as  to  the  seller  and  to  the 
buyer. 

171.  Fair  cost-new.  —  In  most  cases,  as  far  as  the 
appraiser  is  concerned,  it  will  be  necessary  to  prepare 
and  present  the  same  figures  as  would  be  presented  were 
the  case  one  affecting  rates.  It  is  true  that,  strictly 
speaking,  original  cost  in  a  case  of  sale  would  not  seem 
to  be  of  importance,  for  the  buyer  cannot  be  concerned 
with  what  the  property  had  cost  the  original  owner.  This 
assumption  arises  naturally  from  the  association  in  the 
minds  of  most  students  of  this  subject  with  the  sale  of  a 
private  enterprise.  But  in  the  sale  of  a  public  utility  the 
public  must  be  considered,  and  fairness  to  it  demands 
that  the  price  paid  by  the  vendee  shall  not  be  such  as 
will  impose  new  higher  or  unfair  rates. 

When  the  interests  of  the  public  are  considered,  there 
seems  to  be  no  reason  to  believe  that  the  fair  cost-new 
in  the  case  of  sale  should  not  be  the  same  as  would  be 
assigned  to  the  property  as  fair  cost-new  for  rates  pro- 
vided that  figure  had  been  obtained  with  the  well  informed 
judgment  described  in  the  last  chapter.  This  figure, 
therefore,  would  be  not  necessarily  the  original  cost,  not 
necessarily  the  cost-of-reproduction-new  as  of  the  present 
time,  not  necessarily  the  capital  value  of  the  assets  nor 
of  the  return  capitalized.  It  would  be  such  a  figure  as 
would  be  fair  to  the  seller  and  public  under  the  special 
conditions  affecting  the  property  under  consideration. 

A  value  based  upon  such  a  cost-new  might  seem  to 
those  familiar  with  the  sale  of  private  undertakings  as 
imposing  a  burden  upon  the  buyer.  The  buyer  assumes 
the  ownership  and  operation  of  a  property  which  has 
been  some  years  in  existence.  It  is  natural  for  him  to 
contrast  such  a  property  with  a  new  one  and  look  upon 


FAIR  PRESENT  VALUE  —  CONDEMNATION  OR  SALE     237 

the  existing  plant  as  second-hand  and  that,  since  the 
plant  is  not  new,  he  is  entitled  to  a  lower  or  bargain  price. 
The  buyer  may  argue  that  the  cost  of  maintenance  in- 
creases with  age  and  that,  as  he  is  buying  an  older  plant, 
some  recognition  should  be  made  of  the  increased  expense 
of  maintenance  which  he  will  have  to  assume.  More- 
over, he  may  demand  that  he  should  pay  a  lower  price 
for  the  plant  due  to  the  fact  that  he  is  obliged  to  incur  a 
certain  amount  of  risk  arising  from  the  possibility  that 
the  life  assigned  to  the  plant  may  be  wrong  and,  conse- 
quently, that  he  may  have  to  incur  the  cost  of  the  renewal 
of  some  portions  of  the  plant  before  he  has  had  the  time 
necessary  to  accumulate  the  needed  reserves. 

172.  Increased  cost  of  maintenance.  —  Cost  of  main- 
tenance is  a  burden  not  upon  the  buyer  but  upon  the 
public.     A  regulated  public  utility  will  be  entitled  to 
such  rates  as  will  pay  proper  returns  over  and  above 
operating  expenses  in  which  are  included  costs  of  main- 
tenance.   As  a  matter  of  fact,  in  practically  all  cases, 
the  property  sold  will  possess  units  of  widely  differing 
ages.    Under  such  conditions,  especially  if  the  property 
is  increasing  in  size,  the  expense  of  maintenance  as  a 
percentage  of  the  plant  cost  will  be  substantially  uni- 
form. 

When  these  facts  are  considered  there  would  seem  to  be 
no  reason  for  diminishing  the  value  of  the  plant  for  this 
reason.  The  buyer  has  the  virtual  promise  of  the  public 
to  pay  the  reasonable  cost  of  maintaining  the  plant, 
whatever  the  cost  of  maintenance  may  be.  Unreason- 
able cost  of  maintenance  is  cared  for  definitely  in  a  proper 
determination  of  life  (see  section  120).  The  public  does 
not  suffer,  as  it  will  make  no  difference  to  it  whether  this 
expense  of  maintenance  is  paid  to  the  new  owner  rather 
than  to  the  original  owner  of  the  property. 

173.  Uncertainty  as  to  life.  —  Unquestionably  there  is 


238  PUBLIC  UTILITIES 

a  certain  amount  of  uncertainty  as  to  whether  the  perish- 
able property  will  last  out  the  full  life  assigned  to  it  as  the 
basis  upon  which  the  loss  of  value  due  to  age  has  been 
figured.  There  is  always  this  uncertainty  in  making  the 
annual  reserves  for  depreciation,  but  this  uncertainty 
would  be  greater  with  a  new  plant  than  it  would  be  at 
the  time  of  a  sale,  when  the  plant  has  served  already  a 
portion  of  its  life. 

Again,  the  probabilities  are  quite  as  great  that  the 
property  can  be  retained  in  service  longer  than  the  as- 
signed life  rather  than  for  a  shorter  period.  In  fact  the 
probability  is  that,  if  anything,  the  estimated  life  will 
be  less  rather  than  greater  than  the  actual  life. 

But,  more  than  all  the  reasons  above  given,  is  the  fact 
that  the  public  pays  rates  sufficient  to  provide  needed 
depreciation  reserves,  so  that  the  risk  to  the  purchaser  of 
a  public  utility  will  be  no  greater,  in  most  cases,  than  to 
the  original  owner  or  to  any  other  owner  of  a  public  util- 
ity service. 

174.  Value    of    franchise.  —  The    commercial    value, 
which  was  presented  in  cases  involving  rates  as  a  figure  of 
doubtful  value  as  evidence  due  to  the  fact  that  it  is  based, 
necessarily,  upon  existing  rates,  the  very  quantity  under 
investigation,  becomes  a  figure  of  greater  importance  in 
a  case  of  sale,  as  the  question  of  rates  is  not  directly  at 
issue,  and,  in  many  cases,  it  may  be  a  reasonable  assump- 
tion that  the  rates  prevailing  under  the  management  of 
the  original  owner  may  be  continued  unchanged  under 
the  new.     Under  certain  circumstances,  also,  the  value 
attaching  to  a  franchise  may  be  given  a  value  which  could 
not  be  included  as  a  definite  figure  in  a  rate  case. 

175.  Depreciation  in  cases  of  sale.  —  The  same  line 
of  reasoning  holds  as  to  depreciation  in  a  case  of  sale  as 
in  that  where  the  question  of  rates  is  involved.     The 
public  must  be  assured  that  there  will  be  sufficient  funds 


FAIR  PRESENT  VALUE  —  CONDEMNATION  OR  SALE     239 

in  hand  to  make  renewals  of  the  perishable  property 
when  such  renewals  may  be  required.  It  is  to  be  pre- 
sumed that  the  undertaking  has  been  making  reserves- 
to  depreciation  in  the  past.  If  it  has  not,  it  should  have 
done  so.  Such  reserves  may  have  been  invested  in  the 
plant  or  they  may  have  been  held  in  readily  convertible 
securities.  Probably  it  will  make  no  difference,  as  far 
as  the  method  of  appraisal  is  concerned,  as  both  the  cash 
forming  a  portion  of  the  working  capital  of  the  seller,  and 
such  reserves  as  have  not  been  invested  in  the  plant,  will 
be  retained  by  the  seller.  Theoretically,  of  course, 
these  funds  should  be  turned  over  with  the  remainder  of 
the  property  paid  for  by  the  buyer,  but  as  this  may  be 
only  a  transfer  of  money  backward  and  forward  between 
buyer  and  seller,  it  is  usually  not  done. 

176.  Investment  of  buyer  must  be  full  cost-new  of  a 
public  utility  property.  —  The  condition  peculiar  to  a 
sale  of  a  public  utility  exists  in  the  necessity  of  the 
buyer  paying  the  full  cost-new  of  the  property,  —  that 
is  to  say,  the  present  value  of  the  perishable  property 
plus  its  intangible  property  to  which  must  be  added 
such  a  sum  in  cash  or  securities  as  will  guarantee  to  the 
public  a  continuation  of  the  undertaking. 

This  requirement  is  so  foreign  to  ordinary  private  sales 
that  it  must  be  explained  at  some  length  in  order  that 
its  justice  may  be  appreciated  fully. 

A  private  undertaking  would  pay  the  fair  present  or 
market  value  of  a  plant  and  that  cost  would  be  its  invested 
capital.  Upon  this  capital  the  owner  might  establish 
rates  for  service  as  high  as  if  the  purchased  plant  had  been 
new,  trusting  to  his  profits  to  acquire  sufficient  funds  to 
replace  the  plant  when  the  proper  time  arrived. 

A  public  service  undertaking  could  not  do  this  with 
fairness  to  the  public,  for  the  reason  that,  if  a  property 
was  purchased  for  a  fraction  of  its  cost-new,  the  purchase 


240  PUBLIC  UTILITIES 

price,  the  money  actually  invested  by  the  owner,  would 
be  the  fair  value  upon  which  the  rates  charged  the  public 
should  be  based.  The  annual  reserves  would  be  figured 
on  the  cost-new  but  at  the  time  of  renewal  would  not  be 
sufficient  to  pay  for  the  new  plant.  New  money  would 
have  to  be  contributed  by  the  stockholders  and  higher 
rates  would  have  to  be  paid  by  the  public  for  the  same 
service,  a  condition  unfair  to  the  public  and  to  the 
vendor. 

On  the  other  hand  the  buyer,  who  invests  in  the  enter- 
prise the  full  cost-new  of  the  property,  would  pay  to  the 
vendor  the  fair  present  value  of  the  property  and  would 
hold  or  invest  in  plant  needed  by  the  public  an  amount 
of  money  sufficient  to  maintain  the  proper  capital  assets 
of  the  undertaking.  The  public  is  thus  guaranteed  as 
to  the  continuation  of  the  enterprise,  and  the  necessary 
uniformity  of  rates  is  maintained. 

177.  Present  value  in  case  of  sale.  —  The  present 
value  will  be  clearly  the  cost-new  less  the  loss  which  has 
accrued  to  the  investment  in  perishable  property  aris- 
ing from  its  years  of  service.  The  question  that  next 
arises  is  how  shall  this  loss  in  value  be  determined. 

To  take  the  simplest  case  first,  let  it  be  assumed  that 
reserves  for  depreciation  have  been  made  by  the  vendor 
regularly  in  the  past  and  have  been  held  by  him  in  out- 
side securities  upon  which  interest  has  been  obtained. 
In  other  words,  none  of  the  depreciation  reserves  have 
been  invested  in  plant.  Then,  clearly,  if  at  the  time  of 
the  appraisal  it  can  be  shown  that  the  amount  in  the 
reserves  will  equal  the  cost-new  at  the  end  of  the  life  of 
the  plant,  the  plant  plus  the  reserves  will  equal  the  cost- 
new  and  the  price  to  be  paid  to  the  vendor  is  the  cost-new 
of  the  property.  Or,  if  the  vendor  retains  the  securities 
representing  the  depreciation  reserves,  the  price  to  be 
paid  to  the  vendor  is  the  cost-new  less  the  value  of  the 


FAIR  PRESENT  VALUE  — CONDEMNATION  OR  SALE     241 

securities.  Thus,  in  either  case,  the  vendor  obtains  the 
cost-new  of  his  property,  thereby  obtaining  the  full  value 
of  his  investment  in  the  public  utility.  The  vendee  either 
obtains  the  depreciation  reserves  of  the  vendor  or  invests 
as  a  new  depreciation  reserve  a  like  amount,  thereby  guar- 
anteeing to  the  public  the  perpetuation  of  the  service. 
Thus  it  is  seen  that  this  method  is  fair  to  the  seller  and  to 
the  public.  It  is  fair  to  the  public  in  that  the  capital 
assets  of  the  new  undertaking  remain  the  same  as  those 
of  the  older,  and,  consequently,  there  will  be  no  changes 
in  rates;  the  rates,  moreover,  will  be  based  upon  the  fair 
present  value  of  the  property  in  use  and  useful  to  the 
public. 

The  justice  of  this  method  to  the  buyer  may  be  ques- 
tioned by  those  who  cannot  divorce  from  their  minds 
the  usual  prices  and  methods  of  sale  of  private  enter- 
prises. A  public  service  undertaking  cannot  obtain  any 
advantage  from  a  purchase  made  at  a  bargain  price. 
It  is  entitled  to  a  fair  return  upon  the  investment.  If 
the  investment  is  unduly  small  owing  to  the  small  price 
paid  for  the  property,  the  new  owner  can  earn  a  return 
based  upon  that  investment  only.  When  this  property 
has  to  be  replaced,  new  capital  must  be  brought  in  and, 
consequently,  a  new  basis  of  rates  established.  This 
increase  would  go  on  gradually  until  all  of  the  property 
originally  purchased  had  been  replaced.  Such  increases 
in  rates  are  annoying  and  unfair  to. the  public. 

The  only  proper  way  of  looking  at  a  sale  of  a  public 
utility  is  to  consider  that  the  sale  is  simply  a  transfer  of 
the  ownership  in  a  continuing  enterprise.  The  new  owner 
takes  possession  of  the  entire  property  of  the  former  owner 
and  recognizes  that  the  property  purchased  did  not  belong 
necessarily  entirely  to  the  vendor  but  to  the  public  pos- 
sibly as  well. 

It  is,  therefore,  a  necessary  prerequisite  in  a  case  of 


242  PUBLIC  UTILITIES 

sale  to  have  a  complete  examination  made  of  the  past 
operations  of  the  utility  in  order  to  ascertain  whether 
depreciation  reserves  had  been  invested  in  plant  or 
whether  new  money  had  been  introduced  by  the  under- 
taking into  its  reserves  for  the  sake  possibly  of  inflating 
the  value  of  the  property. 

The  above  illustrates  the  principle  peculiar  to  a  sale  of 
a  public  utility.  In  a  practical  case  the  appraiser  finds 
plant  of  a  certain  cost-new  and  of  a  certain  age  and  life. 
It  is  for  the  tribunal,  whose  duty  it  is  to  assign  the  fair 
selling  price,  to  take  these  figures,  and,  with  a  knowledge 
of  the  past  financial  history  of  the  undertaking,  determine 
such  a  figure  as  will  be  fair  to  all  three  parties  concerned. 

Justice  to  the  public  demands  that  the  price  for  the 
property  shall  not  produce  higher  rates  to  be  paid  to  the 
vendee  than  were  paid  previously  to  the  vendor. 

Justice  to  the  vendor  demands  that  he  should  obtain 
his  original  investment  in  the  property  provided  that 
the  value  of  the  investment  has  been  maintained. 

Justice  to  the  vendee  demands  that  he  shall  pay  no 
more  for  the  property  than  will  make  it  possible  for  him 
to  obtain  a  fair  return  upon  his  investment  and  be  enabled 
to  renew  the  perishable  property  when  it  becomes  no 
longer  serviceable. 

No  definite  rule  can  be  formulated  as  to  the  method 
of  ascertaining  this  price.  It  is  evident  that  the  rules, 
which  were  laid  down  as  possibly  useful  in  figuring  fair 
value  for  rates,  may  not  be  applicable  for  such  cases  as 
are  being  now  considered,  as  it  is  unusual  for  the  vendor 
to  turn  over,  with  the  remainder  of  the  property,  the 
reserves  that  have  been  accumulating  during  his  owner- 
ship. If  the  previous  rule,  that  the  straight  line  method 
was  to  be  followed  when  plant  alone  without  reserves 
was  to  be  appraised,  was  adopted,  then  in  most  prac- 
tical cases  the  straight  line  method  only  would  be  used 


FAIR  PRESENT  VALUE  —  CONDEMNATION  OR  SALE     243 

in  ascertaining  loss  of  value  in  cases  of  sale.  As  must  be 
apparent  from  what  has  been  said  in  the  preceding  pages, 
full  justice  would  not  be  accorded  by  a  strict  adherence 
to  such  a  rule. 

Full  justice  to  all  three  parties  interested  is  obtained 
only  by  using  such  method  as  will  determine  what  por- 
tion of  the  present  cost-new  is  represented  by  the  invest- 
ment of  the  vendor  and  what  portion  by  the  investment  of 
funds  contributed  by  the  public,  as  ascertained  by  a 
consideration  of  the  financial  conditions  presented  by  the 
special  case  under  investigation.  In  other  words,  the 
fair  selling  price  can  be  determined  only  by  a  well-informed 
judgment. 


CHAPTER  XIV 

GENERAL  CONSIDERATION  RELATIVE  TO  THE  REGULATION  OF 
PUBLIC  UTILITY  UNDERTAKINGS 

178.  Conduct  of  private  undertakings. 

179.  Conduct  of  public  utility  undertakings. 

180.  Dangers  involved  in  regulation  of  public  utility  undertakings. 

181.  Avoidance  of  dangers  of  regulation. 

182.  Obligations  of  public  to  public  utility  undertaking. 

183.  Obligation  of  public  utility  undertaking  to  the  public. 

184.  Maintenance  of  the  value  of  the  stockholders'  investment. 

185.  Treatment  of  depreciation  reserves. 

186.  General  conclusions. 

178.  Conduct  of  private  undertakings.  —  A  private 
undertaking,  usually  in  competition  with  others  of  a 
similar  nature,  is  privileged  to  charge  such  rates  for  the 
commodity  or  service  furnished  as  will  be  productive  of  as 
great  a  profit  as  can  be  obtained  and,  at  the  same  time, 
retain  the  custom  and  good  will  of  its  customers.  There 
is  every  possible  incentive  to  a  private  undertaking  for 
the  establishment  of  a  good  organization,  the  employ- 
ment of  the  most  skillful  men  and  for  the  development  of 
new  methods  or  devices  which  will  tend  to  reduce  the 
cost  of  its  product  and  thus  enable  it  to  increase  its  profits 
by  means  of  improvements  not  possessed  by  its  com- 
petitors. 

The  profits  made  by  such  private  undertakings  can 
be  treated  in  any  manner  that  seems  best  to  the  owners; 
dividends  may  be  increased  or  excess  profits  can  be  held 
in  the  form  of  a  surplus  designed  to  maintain  dividends 
during  less  successful  years.  The  reserves  for  deprecia- 
tion can  be  made  as  large  or  as  small  as  may  be  deemed 
desirable.  The  reserves,  that  may  be  set  aside,  belong 


PUBLIC  UTILITY  UNDERTAKINGS  245 

to  the  undertaking  and  can  be  used  in  any  manner  that 
may  seem  to  the  directors  as  conducive  to  the  best  inter- 
ests of  the  undertaking. 

Competition  and  the  necessity  of  self-preservation  are 
the  means  whereby  the  character  of  the  product  or  ser- 
vice as  well  as  the  prices  charged  the  users  are  automat- 
ically regulated. 

179.  Conduct  of  public  utility  undertakings.  —  The- 
oretically, at  least,  the  need  of  regulation  of  undertakings 
furnishing  public  utilities  becomes  apparent  only  when 
competition  does  not  exist.     The  state  or  municipal- 
ity has  recognized  the  wasteful  duplication  of  property 
and  human  energy  which  results  when  the  same  utility 
is  afforded  by  two  similar  undertakings  in  the  same 
community.     A  single  undertaking  can  furnish  a  utility 
of  a  certain  kind  with  less  cost  to  the  public  as  a  whole. 
But  this  freedom  from  competition  has  removed  the  stim- 
ulus present  in  usual  trade  relations  and  the  states  have 
found  it  necessary  to  supervise  the  conduct  of  such  pub- 
lic service  undertakings  to  see  that  the  character  and 
prices  of  the  utilities  sold  are  satisfactory  for  the  public 
and  reasonable  for  the  undertaking. 

Thus  it  is  seen  that  a  public  utility  undertaking  must 
consider  not  only  its  own  interests  but  is  forced  to  con- 
sider the  rights  of  the  public  in  all  of  its  operations. 

The  introduction  of  the  considerations  of  the  rights 
of  the  public,  in  the  case  of  public  utility  undertakings, 
produces  a  radical  difference  between  the  conduct  of  such 
undertakings  and  those  of  a  private  nature.  This  same 
consideration  introduces  radical  differences  when  ques- 
tions requiring  valuations  are  involved. 

180.  Dangers  involved  in  regulation  of  public  utility 
undertakings.  —  The  fact  cannot  be  disguised  that,  if 
there  is  to  be  exercised  by  the  state,  —  or  by  boards 
invested   with    state   authority,  —  a   meticulous   super- 


246  PUBLIC  UTILITIES 

vision  of  the  operation  of  public  utility  organizations 
and  such  undertakings  are  to  be  permitted  no  more  than 
a  moderate  return  upon  the  money  invested  in  the  prop- 
erty in  use  or  useful  to  the  public,  stimulus  to  improve- 
ments in  organization,  methods  or  devices  has  been 
removed  to  a  very  large  degree.  The  greatest  possible 
incentive  to  inventions  for  improving  or  cheapening  a 
product  comes  when  a  reward  for  such  labor  and  skill  is 
manifested  by  an  ability  to  undersell  a  competitor.  The 
greatest  advances  in  all  arts  have  come  by  the  employ- 
ment of  highly  specialized  men  whose  efforts  have  been 
directed  by  the  undertaking  employing  them  toward  im- 
provements in  methods  or  machines  whereby  the  charac- 
ter of  a  product  or  service  may  be  improved  or  its  cost 
reduced.  The  cost  of  this  work  to  the  undertaking  is 
large  but  the  reward  obtained  by  it  is  in  many  cases  enor- 
mous. In  the  case  of  a  public  utility  there  can  be  no 
reward,  if  the  law  is  strictly  enforced,  for,  if  the  product 
is  cheapened,  the  rates  must  be  lowered  for  the  reason 
that  no  more  than  a  certain  definite  rate  of  return  can  be 
paid  upon  the  investment.  Further  than  this,  it  is  prob- 
able that  the  courts  will  say  that  the  cost  of  such  devel- 
opment work  cannot  be  regarded  as  an  expense  of  the 
undertaking  to  be  included,  properly,  with  the  costs  of 
operation.1 

Thus,  on  the  mechanical  side  of  the  property  and  in 
the  operation  of  the  plant,  all  incentive  toward  improve- 
ments and  development  is  removed,  and  all  advances  in 
the  art  must  be  sought  outside  the  undertaking. 

What  is  true  of  the  physical  portion  of  the  property  is 
equally  true  of  the  organization  and  of  the  methods 
employed  in  the  conduct  of  the  business.  The  courts 
have  ruled,  that  the  costs  to  the  user  of  the  commodity 

1  See  Capital  City  Gas-Light  Co.  v.  City  of  Des  Moines,  72  Fed.  829 
(1896). 


PUBLIC  UTILITY  UNDERTAKINGS  247 

or  service  obtained  in  one  community  can  be  no  criterion 
of  the  costs  in  another,  owing  to  the  fact  that  identical 
plants  rarely  exist  in  two  places.  While  this  ruling  is 
regarded  by  public  service  commissions,  when  they 
have  had  occasion  to  investigate  the  operating  costs  of 
public  utility  undertakings  within  their  jurisdiction,  still 
it  is  not  at  all  infrequent  to  find  that  the  basis  of  the 
salaries  to  be  paid  the  officials  of  an  undertaking  has 
been  fixed  by  comparison  with  the  salaries  paid  elsewhere. 
Such  a  practice  will  be  productive,  naturally,  of  the 
establishment  of  a  certain  uniformity  in  the  salaries  paid 
officials,  without  the  possibility,  as  in  a  private  under- 
taking, of  obtaining  men  of  exceptional  executive  ability, 
who  are  able  to  advance  the  interests  of  the  undertaking 
employing  them  by  better  organization  and  better 
methods  of  conducting  the  business. 

Thus  it  is  seen  that  a  rigid  enforcement  of  the  powers 
of  the  state  in  the  regulation  of  the  operation  of  public 
utility  undertakings  inevitably  suppresses  the  enterprise 
and  initiative  essential  in  the  successful  operation  of  a 
private  undertaking. 

The  same  conditions  are  involved  when  the  financial 
questions  relative  to  a  public  service  undertaking  are 
considered.  If  the  state  adheres  rigidly  to  the  principle 
that  a  public  utility  can  obtain  no  more  than  a  moderate 
return  upon  the  money  invested  in  the  enterprise,  cap- 
ital will  not  be  forthcoming  and  the  public  will  be  deprived 
of  service  which  can  be  furnished  more  advantageously 
by  an  undertaking  than  by  the  community  itself. 

181.  Avoidance  of  dangers  of  regulation.  —  Most  if 
not  all  of  the  dangers  above  described  can  be  avoided  by 
a  liberal  and  broad-minded  consideration  on  the  part  of 
state  authorities  of  the  needs  of  the  undertakings  as  well 
as  of  the  public. 

A  public  utility  undertaking  which  is  ably  managed 


248  PUBLIC  UTILITIES 

and  can  obtain  with  regularity  and  uniformity  a  fair 
rate  of  return  is  capable  of  serving  the  public  better  than 
if  it  were  restricted  both  in  its  expenses  and  in  its  return 
to  its  own  stockholders.  The  undertaking  and  the  pub- 
lic are  mutually  dependent  upon  each  other.  Each  has 
obligations  toward  the  other  which  must  be  fulfilled.  It 
is  necessary  that  these  obligations  should  be  understood 
fully  both  by  the  public  and  by  the  undertakings. 

182.  Obligations  of  public  to  public  utility  undertaking. 
—  It  must  be  recognized  by  the  public  that  stockholders 
of  most  public  utility  undertakings  at  the  outset  of  their 
enterprise  invested  their  money  in  property  designed 
to  afford  the  public  a  service  which  it  did  not  possess 
before;  that  there  was,  in  most  cases,  a  degree  of  uncer- 
tainty or  hazard  involved  which  no  municipality  would 
be  justified  in  encountering  itself;  that,  as  the  law  exists, 
the  undertaking  can  expect  no  profit  upon  its  invest- 
ment except  the  small  and  doubtful  one  arising  from  the 
gradual  increase  in  costs  due  to  the  growth  of  the  coun- 
try, —  in  other  words,  to  what  is  known  as  the  unearned 
increment;  that  the  only  inducement  for  capital  to  enter 
upon  an  undertaking  of  this  kind  is  a  certainty  of  return 
and  a  return  somewhat  higher  than  that  obtained  in 
other  classes  of  investment,  where  there  is  a  reasonable 
expectation  of  profit;  that  such  large  and  hazardous 
undertakings  require  men  of  exceptional  skill  and  ability 
to  produce  a  good  utility  at  a  reasonable  cost. 

To  meet  these  obligations  the  public  must  recognize 
that  the  rates  paid  by  them  for  the  service  or  commod- 
ity obtained  must  be  sufficiently  high  to  produce  a  gross 
return  which  will  pay  the  operating  expenses  of  the  under- 
taking, pay  a  liberal  contribution  toward  a  fund  to  assure 
the  continuation  of  the  service  of  the  utility  and  to  pay 
to  the  stockholders,  those  who  have  invested  their  money 
in  the  enterprise,  a  liberal  return. 


PUBLIC  UTILITY  UNDERTAKINGS  249 

Probably  no  feature  of  the  relations  between  the  public 
and  public  utility  undertakings  requires  more  accentuation 
than  the  fact  that  it  is  just  and  right  for  the  public, 
through  the  rates  paid  by  them  for  the  service  or  commod- 
ity obtained,  to  contribute  toward  a  fund  to  assure  the 
continuation  of  the  service  of  the  utility  without  obli- 
ging the  utility  to  increase  its  investment,  in  other 
words,  to  create  ample  funds  as  reserves  for  depreciation. 
Until  the  full  justice  of  this  obligation  is  appreciated,  the 
public  or  those  representing  its  interest  are  inclined  to  the 
belief  that,  as  depreciation  reserves  are  used  for  the  con- 
struction of  the  property  and  as  the  money  comes  from 
the  public,  it  is  not  just  to  them  to  pay  a  return  to  the 
stockholders  of  the  undertaking  upon  these  funds.  This 
misunderstanding  of  the  true  nature  of  depreciation 
reserves  is  clearly  indicated  in  the  following  argument :  — 

"We  see  no  reason  why  plaintiff,  in  addition  to  operating 
expenses,  repairs,  and  other  ordinary  charges,  should  be 
allowed  to  reduce  the  apparent  profits  by  deductions  for  a  res- 
toration or  rebuilding  fund.  The  setting  aside  of  such  a  fund 
may  be  good  business  policy,  and,  if  the  company  sees  fit  to 
devote  a  portion  of  its  profits  to  that  purpose  (though,  as  we 
understand  the  record,  no  such  fund  has  yet  been  created), 
no  one  can  complain;  but  it  is  in  no  just  sense  a  charge  affect- 
ing the  net  earnings  of  the  works.  To  hold  otherwise  is  to  say 
that  the  public  must  not  only  pay  the  reasonable  and  fair  value 
of  the  services  rendered,  but  must,  in  addition,  pay  the  company 
the  full  value  of  its  works  every  40  years — the  average  period 
estimated  by  plaintiff  —  for  all  time  to  come."  1 

The  Supreme  Court  of  the  United  States  in  the  Knox- 
ville  Case  has  settled  definitely  this  question  and  has 
explained  fully  the  obligations  of  the  public  to  safeguard 
the  continuation  of  the  service  of  the  undertaking.  This 
decision  has  been  quoted  already  in  the  Chapter  dealing 

1  Cedar  Rapids  Co.  v.  Cedar  Rapids,  118  Iowa,  263;  91  N.  W.  1081 
(1902). 


250  PUBLIC  UTILITIES 

with  depreciation,  but  the  following  words  may  be  quoted 
to  emphasize  the  importance  and  propriety  of  this  contri- 
bution from  the  public. 

"It  is  not  only  the  right  of  the  company  to  make  such  a 
provision,  but  it  is  its  duty  to  its  bond  and  stock  holders,  and, 
in  the  case  of  a  public  service  corporation  at  least,  its  plain 
duty  to  the  public.  If  a  different  course  were  pursued,  the 
only  method  of  providing  for  replacement  of  property  which 
has  ceased  to  be  useful  would  be  the  investment  of  new  capital 
and  the  issue  of  new  bonds  or  stock.  This  course  would  lead 
to  a  constantly  increasing  variance  between  present  value  and 
bond  and  stock  capitalization  —  a  tendency  which  would  inev- 
itably lead  to  disaster  either  to  the  stockholders  or  to  the  pub- 
lic, or  both.  If,  however,  a  company  fails  to  perform  this 
plain  duty  and  to  exact  sufficient  returns  to  keep  the  invest- 
ment unimpaired,  whether  this  is  the  result  of  unwarranted 
dividends  upon  overissues  of  securities,  or  of  omission  to  exact 
proper  prices  for  the  output,  the  fault  is  its  own." 

This  decision  clearly  establishes  the  only  principle  that 
is  capable  of  yielding  the  stability  of  service  and  rates 
which  is  essential  for  the  good  of  the  public  as  well  as  the 
stockholders  of  the  undertaking.  It  is  manifest  that  if  a 
company  could  obtain  only  a  fair  return  upon  its  invest- 
ment and,  following  the  former  decision,  was  obliged  to 
make  its  reserves  from  such  return,  not  only  would  the 
property  be  ruined  but  no  money  would  be  invested  in 
undertakings  where  such  an  exaction  was  enforced.  The 
return  allowed  may  be  6,  7  or  8  per  cent  of  the  value  of 
the  property  invested,  but  the  needed  reserves,  in  many 
cases,  would  be  as  high  as  8,  9  or  10  per  cent  of  the  same 
investment. 

183.  Obligation  of  public  utility  undertaking  to  the 
public.  —  It  must  be  recognized  by  public  utility  under- 
takings that  they  have  been  given  by  the  public  certain 
rights  and  privileges;  that,  instead  of  building  and  oper- 
ating the  plant  itself,  the  public  has  allowed  the  under- 


PUBLIC  UTILITY  UNDERTAKINGS  251 

taking  to  take  or  use  property  and  in  most  cases  this 
privilege  has  been  extended  to  it  alone;  that  virtually 
its  plant  is  a  municipal  property  built  and  operated 
for  the  public  good  but  with  the  money  of  private  indi- 
viduals; that  in  return  for  these  privileges  the  under- 
taking must  give  the  public  good  and  modern  service 
at  reasonable  rates;  that  the  rates  are  reasonable  when 
they  yield  a  gross  income  sufficient  to  pay  proper  and 
liberal  operating  expenses,  an  ample  installment  toward 
the  depreciation  reserve  funds  and  a  just  and  liberal 
return  to  those  who  have  risked  their  money  in  the  under- 
taking; that  this  return  shall  be  based  upon  the  value  of 
the  property  in  use  and  useful  to  the  public;  and  that  the 
reserves  for  depreciation  shall  be  conserved  by  the  under- 
taking for  the  purpose  for  which  they  were  contributed, 
i.e.,  to  make  good  portions  of  the  property  as  they  become 
no  longer  serviceable. 

There  are  two  features  only  of  these  obligations  of 
public  utility  undertakings  which  are  not  self-evident. 
One  is  that  the  undertaking,  in  order  to  maintain  a  fair 
rate  of  return  upon  funds  originally  invested  in  the  prop- 
erty, must  keep  the  value  of  their  property  unimpaired 
at  all  times.  The  other  is  that  the  reserves  for  depre- 
ciation, although  the  property  of  the  undertaking,  were 
contributed  to  it  for  a  specific  purpose  and  can  be  used 
only  for  that  purpose. 

184.  Maintenance  of  the  value  of  the  stockholders' 
investment.  —  An  undertaking,  which  has  invested  its 
money  wisely  and  properly  for  the  purpose  of  supply- 
ing the  public  with  a  needed  service,  will  find  that  the 
value  of  the  property,  in  most  cases,  will  depreciate, 
owing  to  the  limited  tenure  of  life  of  many  of  its  elements. 
This  gradual  diminution  in  value  can  be  made  good  by 
the  depreciation  reserves,  so  that  there  will  be  always 
in  hand  property  of  the  value  of  the  stockholders'  invest- 


252  PUBLIC    UTILITIES 

ment,  represented  either  by  plant  value  or  plant  of  re- 
duced value  and  depreciation  reserves,  equal  to  the  amount 
by  which  the  value  of  the  plant  has  been  reduced.  So 
long  as  this  total  value  of  the  property  is  maintained  the 
rate  of  return  can  be  based  upon  the  original  investment. 

Unfortunately,  the  fairness  of  the  principles  above 
outlined  are  not  apparent  in  many  cases,  owing  to  ques- 
tions arising  from  the  treatment  of  the  depreciation 
reserves  held  by  the  undertaking.  This  subject  is  of 
fundamental  importance  and  is  one  of  the  features  in- 
volved in  valuations  of  properties  which  needs  most 
careful  discussion. 

The  depreciation  reserves  obtained  by  the  undertaking 
from  the  public  are  not  immediately  needed  for  the 
replacement  of  plant  but  are  held  by  the  undertaking  for 
this  purpose.  In  some  cases  these  reserves  are  invested 
in  outside  securities  drawing  interest  and,  in  other  cases, 
are  invested  in  needed  extensions  of  the  plant  of  the 
undertaking. 

The  difficulties  which  are  frequently  present  in  the 
minds  of  those  considering  this  subject  are:  first,  as  to 
the  justice  to  the  public  of  an  undertaking  being  allowed 
to  earn  a  full  return  upon  money  contributed  by  the 
public,  and  second,  if  the  undertaking  is  obtaining  a  return 
in  the  form  of  interest  on  the  depreciation  reserves  which 
it  has  invested  in  outside  securities,  as  to  whether  it  is 
right  to  oblige  the  public  again  to  pay  to  the  undertak- 
ing a  return  upon  this  fund. 

The  first  of  these  difficulties  is  removed  when  it  is 
appreciated  that  the  public  pays  a  full  return  only  on  the 
money  invested  in  the  undertaking.  The  value  of  the 
plant  represented  by  that  investment  may  diminish, 
but  the  original  investment  was  made  in  good  faith  by 
the  stockholders  of  the  undertaking  and  they  are  entitled 
to  a  full  return  upon  that  investment  so  long  as  the  under- 


PUBLIC  UTILITY  UNDERTAKINGS  253 

taking  can  produce  the  service  desired  and,  at  the  same 
time,  show  that  there  is  sufficient  property  in  hand  to 
produce  the  same  character  of  service  indefinitely.  It  is_ 
true  that  a  portion  of  the  property  which  the  undertak- 
ing possesses  is  of  the  nature  of  depreciation  reserves, 
obtained  from  the  public,  but  these  reserves  are  not 
used  by  the  undertaking  to  enhance  the  amount  of  their 
investment  and  so  advance  the  rates,  but  rather,  as 
directed  by  the  courts,  to  maintain  the  value  of  the 
investment  unchanged  and,  thus,  bring  about  the  uni- 
formity in  rates,  capital  and  return  essential  to  the 
well-being  of  both  the  public  and  of  the  undertaking. 

This  holds  true  whether  the  reserves  for  depreciation 
are  invested  in  outside  securities  or  invested  in  needed 
extensions  of  the  plant.  In  each  case  the  value  of  the 
original  investment  is  maintained  and  the  undertaking 
can  obtain  a  return  for  its  stockholders  on  that  value 
only.  When  the  reserves  are  invested  in  plant,  the 
amount  which  has  been  invested  in  plant,  its  replacement 
cost,  may  exceed  by  a  large  amount  the  value  of  the  orig- 
inal investment,  but,  if  the  reserves  have  been  properly 
made,  the  then  value  of  the  property  will  be  the  amount 
invested  in  the  property  by  the  stockholders  and  it  is 
upon  that  amount  only  that  a  return  to  the  stockholders 
can  be  made. 

The  second  of  these  difficulties  also  is  removed  when  it 
is  appreciated  that  the  return  to  the  stockholders  is  based 
only  upon  their  investment,  provided  there  is  at  all  times 
property  equal  to  their  investment  in  the  hands  of  the 
undertaking.  If  the  reserves  are  invested  in  outside 
securities  drawing  interest,  the  annuity  paid  by  the  public 
toward  the  depreciation  reserves  need  not  be  as  great. 
The  return  obtained  from  these  invested  reserves  may  not 
have  been  segregated  and  made  a  part  of  the  deprecia- 
tion reserves,  but  shown  as  a  portion  of  the  gross  income 


254  PUBLIC  UTILITIES 

of  the  undertaking.  Such  a  practice  may  lead  to  account- 
ing difficulties,  but  can  result  in  no  unfairness  to  the 
public  as  the  undertaking  can  earn  only  a  fair  return 
upon  its  "then"  property  and  it  will  be  necessary  to  trans- 
fer the  surplus  earnings  to  the  depreciation  reserves  to 
make  the  then  value  of  their  property  equal  to  the  value 
of  the  original  investment.1 

The  same  line  of  reasoning  holds  good  when  deprecia- 
tion reserves  are  invested  in  plant,  provided  that  it  is 
clearly  recognized  that,  in  such  a  case,  the  question  of  a 
return  upon  the  depreciation  reserves  is  a  mere  fiction, 
as  the  public  in  the  long  run  contributes  the  entire  orig- 
inal investment.  The  undertaking  can  pay  its  stock- 
holders only  the  fair  return  upon  the  original  investment, 
provided  it  has  property  then  equal  in  value  to  that 
amount. 

185.  Treatment  of  depreciation  reserves.  —  The  sec- 
ond feature  of  the  obligations  of  a  public  utility  under- 
taking to  the  public  is  a  proper  recognition  and  treatment 
of  the  depreciation  reserves.  The  undertaking  must 
recognize  that,  fundamentally,  the  depreciation  reserves 
are  contributions  made  to  the  undertaking  by  the  public 
for  the  specific  purpose  of  maintaining  the  value  of  the 
investment  in  property  in  use  or  useful  to  the  public.  The 
depreciation  reserves  are  the  property  of  the  undertak- 
ing, not  to  be  disbursed,  however,  in  any  way  the  under- 
taking sees  fit,  but  only  in  such  a  way  as  will  insure  to 
the  public,  which  has  contributed  the  money,  the  contin- 
uation of  the  service  at  unchanged  rates. 

The  full  significance  of  the  treatment  of  depreciation 
reserve  funds  is  brought  out  most  clearly  when  the  pres- 
ent value  of  a  property  is  considered  in  a  case  of  con- 
demnation or  sale.  In  order  to  obtain  full  justice  to  the 

1  Under  modern  standard  methods  the  above  complication  would  not 
arise. 


PUBLIC   UTILITY  UNDERTAKINGS  255 

public  in  a  case  of  sale,  the  entire  property  of  the  under- 
taking must  be  acquired.  This  property  may  consist 
of  a  plant,  which  has  served  a  portion  of  its  useful  lifer 
and  depreciation  reserves,  which  have  been  contributed 
by  the  public  to  maintain  the  plant  investment  intact. 
The  selling  undertaking  must  turn  over  to  the  buyer, 
theoretically  at  least,  its  entire  property,  plant  and 
depreciation  reserves.  The  buyer,  in  justice  to  the  pub- 
lic, assumes  the  ownership  of  these  reserves,  dedicated, 
however,  to  the  special  purpose  of  restoring  the  plant  to 
its  original  condition  when  it  has  become  no  longer  ser- 
viceable. The  seller  obtains  the  value  of  his  original 
investment  from  the  buyer,  but  the  buyer  assumes  the 
responsibility  of  maintaining  the  value  of  the  invest- 
ment and,  as  an  assurance  of  his  good  faith,  must  hold  in 
reserve  an  amount  equal  to  the  reserves  held  by  the  seller 
at  the  time  of  transfer  of  the  property. 

186.  General  conclusions.  —  In  what  has  been  just 
said,  the  fair  value  of  the  investment  in  the  property 
of  an  undertaking  was  spoken  of  as  the  basis  upon  which 
rates  should  be  made  or  a  just  price  in  case  of  sale,  pro- 
vided that  value  still  existed  in  the  property  at  the  time 
of  investigation. 

The  only  conclusion  that  can  be  obtained  from  a  study 
of  the  subject  of  valuations  of  public  utilities  is  that, 
apart  from  the  appreciation  in  values  which  has  been 
termed  the  unearned  increment,  the  courts  intend  that 
the  basis  of  return  to  the  stockholders  of  public  utility 
undertakings  shall  be  the  money  properly  invested  by 
the  undertaking  and  used  by  it  for  the  benefit  of  the 
public.  In  most  cases,  the  courts  cannot  tell  whether 
the  sums  of  money  represented  by  the  securities  were 
actually  invested  in  the  property;  they  do  not  know 
whether  the  money  was  honestly  expended  in  the  con- 
struction of  the  property;  they  do  not  know  whether  a 


256  PUBLIC  UTILITIES 

large  portion  of  the  property  representative  of  the  stock- 
holders' investment  has  not  already  passed  out  of  exist- 
ence; and  lastly,  they  cannot  tell  whether  the  same 
property  could  not  be  acquired  more  cheaply  at  the  present 
time  than  when  it  was  purchased.  It  is  for  the  purpose 
of  determining  what  sums  of  money  have  been  properly 
invested  by  the  undertaking  in  its  property  and  whether 
there  is  that  value  still  remaining  in  the  property  that  all 
of  the  sets  of  figures  described  in  this  study  are  required 
by  the  court. 

The  decision  as  to  what  is  a  fair  present  value  either  as 
a  basis  for  rates  or  for  a  price  to  be  paid  by  a  buyer  in  a 
case  of  sale  is  formed  upon  personal  judgment,  the  opinion 
of  the  Court  determined  judicially  with  "  sound  and  well 
instructed  judgment." 


INDEX 


Actual  cost:  see  Original  cost 
Administration   expenses:    see   Or- 
ganization cost 
Age  of  plant: 

determination  of,  185 

independent  of  age  of  utility,  191 

mean  age,  153,  186,  192 

pseudo  mean  age,  197 
Allison,  James  E. : 

amortization  of  normal  wear,  205 
Alvord,  John  W.: 

going  value,  83 

period  of  construction,  24 
Amortization : 

bond  discounts,  220 

normal  wear,  205 

through    depreciation    reserves, 

140 
Antiquated  pattern: 

unit  cost,  20 
Appreciation  in  land  value: 

excluded  from  original  cost,  212 

excluded  in  state  investigations 
of  rates,  214 

included  in  replacement  cost,  67 

included  in  court  investigations 

of  rates,  218 
Average  prices:  see  Unit  costs 


B 

Bonds: 

bond  discounts,  56,  112,  219 
return  on  bonds,  233 

Brokerage:  see  Bonds 

Buildings: 

appraisal,  68 

effect  upon  cost  of  land,  22 

hypothetical  replacement,  64 


Capital:  see  Working  capital 
Capitalization : 

of  earnings  defined,  8 

of  earnings,  method  of  figuring, 

73 

Casualties:  see  Insurance 
Cedar  Rapids,  Iowa:  Gas  rate  case 

going  value,  85 

Chicago,   111.:    Telephone  rate  in- 
vestigation 

reserves  for  depreciation,  143 
Cleveland,    Ohio:     Street    railway 
settlement 

good  will,  96 
Commercial  value: 

capitalization  of  earnings,  120 

defined,  115 

of  stocks  and  bonds,  119 
Competition: 

affecting  good  will,  95 

regulation  when  no  competition, 

245 
Consolidated  Gas  case: 

good  will  excluded,  95 

value  of  franchise,  89,  100 
Construction: 

interest  during  construction,  42, 
46 

period  of  construction,  22 

piecemeal  construction,  29,  109 
Contingencies: 

as  an  overhead  charge,  52,  112 
Contractor's  profit: 

excluded  from  replacement  cost, 

57 
Cost: 

compared  with  value,  9 

transformed  to  value,  10 


258 


INDEX 


Cost-new: 

court  investigation  of  rates,  217 
fair  cost-new,  222,  236 
in  cases  of  condemnation,  236 
state  investigation  of  rates,  211 
Cost  of  money,  221 
Cost  of  replacement:   see  Replace- 
ment cost 

Cost  of  reproduction:  see  Replace- 
ment cost 

Current  repair  and  maintenance: 
distinguished  from  depreciation 
36 


Depreciation: 

allowance  for,  in  valuation,  7, 16 

annual  allowance  for,  134 

ascertained  from  mean  life  and 
age,  188 

defined,  7,  182 

deterioration  contrasted,  183 

in  cases  of  sale,  238 

in  rate  cases,  223 

old  plant  not  second-hand,  159 

overhead  charges,  59 

reserves  invested  in  plant,  191 

rule  for  use  of  straight  line  or 
sinking  fund  method,  196 

sinking  fund  method,  198 

straight  line  method,  188 
Depreciation  reserves: 

authority  for,  134 

comparison  of  stockholders'  in- 
vestment with  cost-new,  153 

creation  of,  140 

invested  in  plant,  150 

necessity  for,  249 

saving  to  public  from  reserves 
invested  in  plant,  156 

sinking  fund  method,  141 

straight  line  method,  142 

treatment  of  reserves,  254 
Deterioration:   contrasted  with  de- 
preciation, 183 

Development,  cost  of:  see  Organiza- 
tion 

Development  of  business,  Cost  of: 
see  Going  value 


Discounts  on  sale  of  securities: 
amortization  of,  220 
excluded  from  original  cost,  112 
excluded  from  replacement  cost, 
47,56 


E 


Earnings,  Capitalization  of: 
method  of  figuring,  120 
representative  of  value,  8,  73 
Efficiency:  see  Inefficiency 
Element  of  plant:  definition,  36 
Engineering,  Cost  of:   an  overhead 

charge,  49 

Enid,  Oklahoma  case: 
going  value,  80 

interest  during  construction,  42 
removing  obstructions,  22 
Equally  efficient  plant,  20 
Expert  evidence,  Limitations  to,  2 


Fair  cost-new,  222,  236 

Fair  value: 

court  investigations,  210 
dependent  on  purpose,  14 
determined  by  judgment,  207 
new  properties,  229 
state  regulation,  210 

Franchise  value: 

attribute  of  live  plant,  14,  88,  94 
general  consideration,  96 
in  cases  of  sale,  97.  238 
in  cases  of  taxation,  100 
in  rate  cases,  98 


Gavey,  Sir  John: 

as  to  period  of  construction,  24 
Gloucester,    Mass.:    Water    plant 

purchase 
going  value,  70 
"Going  concern,  Value  as: 

distinguished  from  going  value, 
91 


INDEX 


259 


Going  value: 

attribute  of  live  plant,  14 

cost  of  developing  business,  114 

doubt  as  to  value  in  rate  cases, 

85 

reproduction  of  earnings,  83 
Wisconsin  method,  79,  83 

Good  will: 

attribute  of  live  plant,  14,  88,  94 
definition,  95 


H 

Harlan,  Justice: 

basis  of  fair  present  value,  5 


Identical  reproduction  of  existing 

plant,  20 
Inadequacy: 

due    to    changes    in    financial 
policy,  172 

due  to  engineering  economy,  176 

due  to  unexpected  development, 

176 
Income: 

capitalization  of,  8 

sufficient  to  pay  expenses  includ- 
ing depreciation  reserves,  248 
Inefficiency,  165 
Insurance: 

included  in  unit  cost,  39,  41 
Interest  during  construction: 

an  overhead  charge,  42 

construction  period,  46 

definition,     42 

rate  of  interest,  47 
Inventions : 

cost  of  inventions  excluded  from 

operating  expenses,  246 
Inventory: 

definition,  35 

K 

Kansas   City:     Water   plant   pur- 
chase 
value  as  going  concern,  70 


Kennebec   Water   District:   Water 
plant    purchase  reproduction 
of  identical  plant,  21 
Knoxville,  Tenn.:   Water  rate  case 
abandoned  plant  excluded,  105 
depreciation  reserves,  135,  250 


Land,  valuation  of: 

appraisal,  61 

effect  of  cost  of  buildings  re- 
moved, 22,  64 

increased  cost  due  to  uses,  63 

unearned  increment,  212,  215 
Lawrence,  Justice: 

cost  of  raising  capital,  221 
Legal  expenses: 

an  overhead  charge,  52 
Liabilities: 

form  of  presentation,  122 
Life  of  plant: 

depreciation    dependent    upon, 
158 

estimates  of,  178 

factors  affecting,  165 

importance   of   accurate   deter- 
mination, 140 

inadequacy,  165,  171 

inefficiency,  165 

mean  life,  186 

method  of  figuring  mean  life, 
145 

obsolescence,  165,  169 

operation  of  factors,  177 

physical  life,  164 

tenure  of  holding,  165,  180 

uncertainty    in    case    of     sale, 
237 

useful  life,  164 

wear  and  tear,  165,  168 
Losses  on  tools  and  material: 

a  portion  of  unit  cost,  39,  40 
Louisville,  Ky. :  Telephone  rate  case 

difficulty  in  ascertaining  original 

cost,  107 
Lurton,  Justice: 

good  will,  96 

value  as  going  concern,  11,  85 


260 


INDEX 


M 

Maine     Supreme     Court:      Water 
plant  sales 

commercial  value,  116,  117 

good  will,  96 

original  cost,  104 

period  of  construction,  26 

value  as  going  concern,  70 

worth  of  service  to  consumer,  127 
Maintenance: 

current  repair,  163 

larger  in  older  plants,  237 
Market  value: 

denned,  7,  235 

method  of  determination,  119 

relative  importance,  115 
Massachusetts  Gas  &  Electric  Light 
Commission: 

unearned  increment,  214 
Massachusetts  Validation  Board: 

discount  on  securities,  47 
Metcalf,  Leonard: 

going  value,  83 

period  of  construction,  24 
Michigan  Railroad  appraisal: 

intangible  assets,  73 

unit  cost,  27 
Minnesota  Railroad  Commission: 

original  cost  of  land,  67 


N 


National   Telephone   Company, 
Limited:  Sale  telephone  prop- 
erty 

cost  of  raising  capital,  221 
period  of  construction,  24 
New  York  Public  Service  Commis- 
sion, 1st  District: 
cost  of  land  affected  by  hypo- 
thetical buildings,  66 
Normal  wear,  205 


Obsolescence: 

a  factor  of  depreciation,  169 
Omaha,  Neb. :  Water  plant  purchase 

going  concern  value,  11 


Organization,  Cost  of: 

an  overhead  charge,  51 
Original  cost: 

denned,  106 

difficulty  of  ascertainment,  107 

essential  in  a  valuation,  103 

general  consideration,  102 

overhead  charges,  112 

pavement,  111 

piecemeal  construction,  109 

unit  costs,  109 
Overbuilt  plant,  Cost  of: 

not  a  fair  basis  for  rates,  130 
Overhead  charges: 

definition,  41 

engineering,  49 

interest  during  construction,  42 

legal  expenses,  52 

method  of  application,  57 

organization  cost,  51 


Partnership  of  public  in  utility,  160 
Paving: 

in  court  rate  cases,  218 

in  original  cost,  111 

in  replacement  cost,  33 

in  state  rate  cases,  216 
Present  value: 

abandoned  plant  excluded,  104 

dependent     upon     purpose     of 
appraisal,  3 

determined  by  court  or  commis- 
sion, 4,  5,  90 

figures  indicative  of  value,  4,  5,  6 

necessity  of  figures  indicative  of 

value,  16 

Prices:  see  Unit  costs 
Promotion  costs: 

excluded  from  replacement  cost. 

54 
Property  acquired  by  gift: 

court  rate  cases,  218 

state  rate  cases,  216 
Public  utilities: 

competitive  conditions,  245 

contrasted  with  private  enter- 
prises, 244 


INDEX 


261 


R 

Rate  cases: 

state  and  court,  208 
Rate  of  return,  231 
Renewals:     see    Depreciation    re- 
serves 
Replacement  cost: 

cost  of  pavement  included,  33 
cost  under  present  conditions,  19 
defined,  7,  18 

enhanced  cost  due  to  enlarge- 
ments, 32 

enhanced  cost  due  to  obstruc- 
tions, 21 

general  assumptions,  19 
period  of  construction,  23 
piecemeal  construction,  29 
reproduction  of  identical  plant, 

20 

unit  costs,  25 
wholesale  construction,  29 
Reserves:  see  Depreciation  reserves 
Reserves  for  renewals:    see  Depre- 
ciation reserves 
Return: 

based  on  capital  invested,  226, 

233 
based  on  fair  present  value  of 

property,  227 
fair  return  defined,  231 


3 

Salvage  value: 
defined,  139 
Sanborn,  Judge  W.  H. : 

replacement  cost,  211 
San   Francisco,   Cal.:    Water  rate 

case 

commercial  value,  117 
fair  present  value,  14 
franchise  value,  97 
going  value,  81,  86 
Savage,  Judge:  see  Maine  Supreme 

Court 

Second-hand  plant,  159 
Sinking  fund  method: 

creation  of  depreciation  reserves, 

141 
used  for  plant  and  reserves,  147 


Straight  line  method: 

creation  of  depreciation  reserves, 

142 
used  for  plant  alone,  147 


Texas  railroad  appraisal: 

replacement  cost,  unit  cost,  27 


u 

Unearned  increment  in  land: 

state  rate  investigation,  212,  218 
Unit  cost: 

average  past  prices,  25,  39 

cost  of  labor,  39 

definition,  38 

for  original  cost,  109 

items  included  in,  32 

weighted  mean  prices,  29 


Value:  defined,  9 

Value,  as  going  concern:  see  Value 

inherent  in  live  plant 
Value  inherent  in  live  plant: 
attributes,  14,  69 
capitalization  of  cost  of  develop- 
ment, 79 
capitalization  of  earnings,  73,  75, 

76 

definition,  72 
general  considerations,  87 
means  of  transforming  cost  to 

value,  10 
rate  cases,  219 


W 


Washington  Railroad  Commission: 
value  as  going  concern,  75 

Wear,  Normal,  205 

Wearing  value:  defined,  139 

Weaver,  Justice: 

value  as  going  concern,  85 


262 


INDEX 


Wisconsin  Railroad  Commission: 
commercial  value,  117 
depreciation  reserves,  136 
franchise  value,  99 
going  value,  79,  82 
interest  during  construction,  45 
piecemeal  construction,  31 
preference     for     sinking     fund 

method,  143 

property  acquired  by  gift,  217 
replacement  cost  based  on  nor- 
mal cost,  25,  27 

replacement    cost    of    identical 
plant,  20 


Wisconsin  Railroad  Commission: 
unearned  increment,  215 

Woodhouse,  Sir  James: 

cost  of  raising  money,  221 

Working  capital,  230 

Worth  of  service  to  consumer: 

a  figure  indicative  of  value,  125 
comparison     with     substituting 

plant  excluded,  127 
comparison  with  other  communi- 
ties excluded,  127 
defined,  8 

measurement  of,  129 
profit  inherent  in  worth,  128 


THIS  BOOK  IS  DUE  ON  THE  LAST  DATE 
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